What are Commodity Linked Securities?
Commodity linked securities are investment instruments or securities that are linked to one or more commodity prices. Unlike commodities, which provide no income to the owner, commodity linked securities usually give some payout to its holders.
Commodity Linked Bonds
Commodty linked bonds are securities offered by governments whose yield depends on the price of a specific commodity or a global inflation index. Historically, governments offered loans with coupons or principal indexed to the price of a specific good or a global inflation index during times of high inflation. Commodity linked bonds include an explicit indexation clause, i.e., the bond, by construction, is linked to the price of a commodity or a set of commodities.
- Inflation-indexed gilts first became popular in the UK during the 1980s. The principal and coupons of the bonds are linked to British retail prices.
- The United States first offered Inflation-Indexed Securities in 1997 when the US Treasury introduced the Treasury Inflation Protected Securities (TIPS). The first TIPS was a 10-year government bond that provided a real return of 3.45%. The principal amount is adjusted based on the Consumer Price Index (CPI) biannually. The CPI-adjusted principal is reimbursed after the bond matures.
- Gold bonds and bonds that promise returns based on the price of gold were popular in Europe after the First World War. The bonds were seen as a substitute for holding actual gold bars or coins, which came with high storage (vault costs) and maintenance costs.
Commodity Linked Equities
They are equity issued by companies whose value depends on the price of a commodity or several commodities. The most straightforward example of a commodity linked equity is the stock price of energy companies such as Shell and BP.
- Oil and gas companies are directly affected by the evolution of oil prices. Commodity linked equities include an implicit indexation clause, i.e., the stock is implicitly linked to the price of a commodity or set of commodities through the market. Oil companies often take advantage of economies of scale and reduce such risk through expansion and vertical integration.
- Gold mining companies are directly affected by the evolution of gold prices. Unlike gold-linked bonds that contain an explicit indexation clause (via a contract), the value of a gold mining company depends on mining economics, i.e., the cost of extracting gold vs. the revenue generated by the extracted gold.
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