Commodity-backed bonds are bonds with a connection 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. Generally, a commodity-backed bond is understood to function as a hedge against the possible swing of the economy into a period of inflation.
Sometimes referred to as a gold bond, the commodity-backed bond has the potential to generate more of a return than most other types of bonds. The key to the rate of return has to do with the current market value of the commodities that back the bond. In the event that the commodity 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 repayment on the principle investment.
Because the commodity-backed bond does carry more potential to generate a higher return than a fixed rate bond, there is also more risk involved. While it is unusual, there is always the possibility that the underlying commodities will not perform as anticipated and the return will be less than originally projected. However, most investors consider the degree of risk to be well worth the potential return. In general, a commodity-backed bond tends to carry less volatility than many stock issues.
In many cases, the commodity-backed bond is issued by businesses that have a vested interest in the commodity that is used to back the bond. Since the purpose of the bond issue is to generate revenue and also be able to depend on investors coming back for subsequent bond issues, firms tend to be very realistic about the use of commodities to back the bonds. For this reason, the commodity-backed bond is rarely backed with a commodity that is anticipated to be impacted by an economic recession during the life of the bond.