What is a Commodity-Backed Bond
A commodity-backed bond is an investment whose value is directly related to the price of a specified commodity. Bonds are a fixed-income investment where an investor loans money to a corporation or the government in return for interest or coupon payments. Most bonds have a fixed value, determined at the time of purchase, which is a combination of the bond’s face value and its interest rate.
Unlike most bonds, a commodity-backed bond will experience fluctuations in value because of its basis on the price of the specified commodity. The bond’s issuer will determine how the bond’s value will change with the price of the commodity. As an example, the bond may devalue as a percentage of the commodity or at the same rate.
Also, some commodity-backed bonds gain and lose face value with the commodity’s price, and for others, changes have a basis of changes in the interest rate.
BREAKING DOWN Commodity-Backed Bond
Commodity-backed bonds tend to be long-term bonds, maturing over the course of at least five years. In this way, these backed bonds are frequently used to hedge against inflation. These bonds are good hedges for inflation because most commodities can be expected to gain value over time. As long-term liabilities, these bonds serve as important sources of financing to the companies that issue them. Inflation is the pace at which the prices for goods and services rise and the purchasing power of the currency is falls.
Commodity-backed bonds usually pay a lower coupon rate than regular bonds, since the investor stands to earn more when the commodity gains value. They also frequently have a call option. With a call option, the issuer may call back the bond for redemption at a specified time before they reach maturity. These qualities of commodity-backed bonds help protect the issuer from overly large payments to investors if the commodity’s price goes up significantly.
Companies which produce the associated commodity will generally be the issuer of these bonds. Some of the commodities which they may link to include oil, gold, and coal. In fact, another name for these bonds is gold bonds.
Also, Investors tend to purchase commodity-backed bonds as a form of speculation when they believe that the price of that commodity will rise.
Volatile Nature of Commodity-Backed Bonds
Commodities can be quite volatile, which means that their prices can fluctuate a great deal. Thus, a commodity-backed bond carries a degree of risk for the investor. Regular bonds usually appeal to investors who want a predetermined yield with little to no risk. Commodity-backed bonds do not offer this. Instead, they are attractive to investors interested in speculating, and those who are willing to carry a degree of risk.
If the commodity loses value, the bondholder may see their bond’s coupon rate or face value fall. If this happens, it will lessen their overall yield. Yield is the income return from an investment, such as the interest or dividends received from holding the particular security.
There is the possibility, however, that a commodity-backed bond will generate a higher yield for the investor than a traditional bond. With their basis being on a commodity, everything is dependent on the market.