Definition
The term commodity-backed bonds refers to debt securities that are linked to the price of a commodity. These securities are typically issued in one of two ways. The rate of interest paid on the bond can change as the price of the commodity fluctuates. Alternatively, the face value of the bond can increase or decrease as the price of the commodity changes.
Since commodity-backed bonds are typically issued for a term of five years or more, they represent a long term obligation of the company, and are shown in the long term liabilities section of the balance sheet.
Explanation
Issuing long-term bonds represents an important source of financing for many large companies. Commodity-backed bonds, also known as asset-backed bonds, typically carry maturities of five years or longer and are classified as long-term debt obligations.
Commodity-backed bonds are normally issued by companies that produce the commodity. Examples include oil, coal, silver, gold and other rare metals. If the bond's interest rate is indexed to the commodity, then as the price of the commodity rises, the interest rate paid on the bond increases. This mechanism offers the investor the opportunity to speculate while at the same time offering a steady source of income.
When the face value of the bond is linked to the commodity, the offer to the investor might take the form of $1,000 or one ounce of gold, whichever is higher at maturity. (The assumption here is the price of gold was around $1,000 per ounce when the bond was issued.)
Since this feature provides the investor with the opportunity to speculate on the underlying commodity, the issue will carry a lower coupon rate than debt not possessing this feature. This type of security would be attractive to investors if they believed the price of the underlying commodity will increase over time.
Finally, commodity-backed bonds may contain additional features such as the ability for the issuing company to redeem, or call, the debt prior to its maturity.
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