Commodity-backed bonds are tied to the current price of the underlying commodity and can generate higher returns but also involve more risk. They are issued by companies with a vested interest in the commodity and tend to have less volatility than many equity issues.
Commodity-backed bonds are bonds that are tied to the current price of the underlying commodity that is used to guarantee the value of the investment. This is different from the practice with other types of bonds, where the value of the bond is determined by the fixed dollar amount offered at the time the bond is purchased. In general, a commodity-backed bond is understood to function as a hedge against the possible swing of the economy in a period of inflation.
Sometimes referred to as a golden bond, the commodity-backed bond has the potential to generate more returns than most other types of bonds. The rate of return key has to do with the current market value of the products backing the bond. In the event that the product performs at a higher level than anticipated at the time the bond is purchased, the investor will receive higher interest payments and/or a higher return on the principal investment.
Because the commodity-backed bond has more potential to generate higher returns than a fixed-rate bond, there is also more risk involved. While unusual, there is always the possibility that the underlying commodity may not perform as expected and the performance will be less than originally anticipated. However, most investors believe that the degree of risk is well worth the potential return. In general, a commodity-backed bond tends to have less volatility than many equity issues.
In many cases, the commodity-backed bond is issued by companies that have a vested interest in the commodity that is used to back the bond. Since the purpose of bond issuance is to generate income and also be able to depend on investors coming back for subsequent bond issues, companies tend to be very realistic about using commodities to back bonds. For this reason, the commodity-backed bond is rarely backed by a commodity that is anticipated to be affected by an economic downturn during the life of the bond.
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