What Is a Commodity-Backed Bond?
A commodity-backed bond is a type of bond whose value fluctuates based on the price of a specified commodity. Commodity-backed bonds are commonly used by investors wishing to speculate on commodity prices or hedge against inflation.
- Commodity-backed bonds are a type of fixed-income investment that’s value and yield fluctuates based on the price changes of an underlying commodity.
- Commodity-backed bonds are often issued by companies engaged in the production of the underlying commodity as a way for that company to fund long-term projects.
- Commodity-backed bonds generally include a call option, which allows the issuer of the bond to repay—or “call back”—the bond prior to its maturity period.
- Call options can protect the issuer from having to pay excessively large coupon payments in the event that commodity prices increase rapidly after the issuance of the bond.
How Commodity-Backed Bonds Work
Like all bonds, commodity-backed bonds are a type of fixed-income investment that provides the investor with a predictable stream of coupon payments as well as a contractually-guaranteed repayment of their principal upon contract maturity.
Unlike most bonds, however, the value of commodity-backed bonds is directly impacted by changes in the price of the given underlying commodity, such as oil or gold. If the price of the specific underlying commodity increases, then the price and coupon payments of the bond may also rise. Conversely, if the commodity declines in value, then the price and coupons of the commodity-backed bond will also decline.
Commodity-backed bonds are popular among investors who wish to speculate on commodities or else hedge their exposure to inflation risk. Since inflation places upward pressure on commodity prices, commodity-backed bonds should generally rise in value if inflation becomes more severe. This dynamic creates a market demand for commodity-backed bonds as a type of inflation hedge.
Commodity-backed bonds are typically structured with long maturities, which means that they tend to be more sensitive to interest rate changes and inflation. For a company that is issuing them, commodity-backed bonds can be a good way to finance long-term projects, since their maturity periods are similarly long-term in nature. Indeed, it is common for the issuers of commodity-backed bonds to be producers of the commodities. For instance, gold-backed bonds are often issued by companies that produce gold.
Because investors stand to gain from any increases in the price of the underlying commodities, commodity-backed bonds typically pay lesser coupon payments than regular bonds. It is also common for commodity-backed bonds to include a call option, which allows the issuer of the bond to repay—or “call back”—the bond prior to its maturity period. In the event of a call back, the issuer would be required to pay a modest premium to the bondholder as compensation for calling their bond prematurely.
For an issuer, including a call option in the provisions of a commodity-backed bond can be beneficial because it protects them from having to pay excessively large coupon payments in the event that commodity prices increase rapidly after the issuance of the bond. However, from an investor’s perspective, these call provisions can limit the likely upside potential of the bond, since issuers are unlikely to continue paying an especially high coupon payment for the entirety of the bond’s term.