Commodity-Linked Securities
Commodities are often considered a suitable addition to one’s portfolio, allowing them to diversify. Instead of investing in commodities directly, investors can opt for a commodity-linked security. A commodity-linked security is a financial instrument whose returns are linked to the performance of one or more commodities. In this blog, we will take a closer look at commodity-linked securities and understand the risks and benefits of investing in them.
What are Commodity-Linked Securities?
Linked securities are instruments that are linked to another asset. The performance of the instrument depends on the performance of the underlying asset i.e, the commodity.
A commodity-linked security is typically a structured debt instrument that is linked to the prices of one or several commodities. Unlike a regular bond, wherein the interest rate is fixed, a commodity-linked security’s coupon rate depends on the change in the price of the commodity. In some cases, the performance of the commodity can impact the principle amount to be repaid at maturity.
In India, commodity-linked equities are available easily. However, access to commodity-linked debt instruments is somewhat restricted and are available only to institutional investors.
How do Commodity-Linked Securities Work?
Commodity-backed securities are structured in two ways:
Principal-Linked Bonds:
In a principal-linked bond, changes in the linked commodity’s prices impact the principal amount repaid. An increase in the price of the commodity results in an increase in the principal amount repaid to the investor upon maturity and vice versa.
Coupon-Linked Bonds:
In a coupon-linked bond, the principal amount remains unchanged while the coupon rate (interest rate) varies depending on the price on the commodity.
Suppose you invest in a commodity-linked security linked to the price of gold. Now, in case the price of gold increases, you could receive a higher coupon rate, meaning higher interest payout and potential a higher principal if the structure allows for both functions. However, if the gold prices decline, it could not only result in both the principal and the interest payout declining.
Commodity-Linked Equities
Commodity-linked equities are one of the widely accesible commodity-backed securities in India.
A commodity-linked equity refers to the equity or shares of a company whose value is linked to the performance of the underlying commodity.
For example, an oil & gas company’s performance is linked to crude oil prices. When crude oil prices increase, the company can see higher revenue and profitability, which can boost the share price.
Common Commodities
There are several commodity-linked securities that are based on common commodities such as gold, silver, crude oil, and coal, among others. These commodity-linked securities are usually issued by mining or energy companies. The securities are either placed privately or listed publicly.
Advantages of Commodity-Linked Securities
Let’s take a look at some of the key advantages of commodity-linked securities.
Commodity Market Exposure
One of the key benefits of investing in a commodity-linked security is that it allows investors to benefit from positive price movements without having to actually invest in physical goods.
Diversification
Investing in commodity-backed securities can help in portfolio diversification and manage risk across different asset classes, instruments, and commodities.
No Need for Physical Delivery
The process of physical delivery of commodities can be time-consuming, complicated, and consuming. Commodity-linked securities remove the need for taking physical delivery of unlike commodity futures or spot trading.
Inflation Hedge
Certain commodities, such as gold and crude oil, are often impacted by inflation rates. Investors can navigate inflationary and deflationary periods by strategically investing in securities linked with such commodities.
Transparency
Offers investors transparency. Investors can access details about the issuing entity, pricing mechanisms and risk disclosures. Furthermore, SEBI regulations adds a layer of transparency in India.
Risks and Limitations of Commodity-Linked Securities
As an investor, it is vital to be aware of the risks and considerations of any investment avenue. While investing in commodity-linked securities has several benefits, they also have certain limitations.
Market Volatility
Commodity-backed securities are directly linked to commodity prices which are influenced by numerous factors such as geopolitical tensions, global cues, and supply-chain, making them volatile.
Counterparty Risk
Similar to other debt instruments, a commodity-linked bond could be exposed to credit risk due to the issuing entity. When the issuing entity fails to make repayments or if it faces operational challenges due to commodity production, it exposes investors to risks.
Liquidity
Commodity-linked securities, especially commodity-linked bonds are not actively traded in the secondary market and are often placed privately. This can lead to lower liquidity and make it difficult for investors to exit the funds before expiry.
Taxation and Regulations
As an investor, it is important to aware of the regulations and tax implications surrounding their investment in commodity-linked securities. Changes in regulations can affect the classification when it comes to taxation and also impact accessibility at times.
Requires Knowledge of the Commodity Markets
Since these securities are linked with commodity prices, an investor should be aware of the factors impacting commodity prices, such as government policies, taxes, and weather events.