The biggest news story in asset allocation so far this year is commodities, and issuance of bonds linked to the prices of oil, sugar, zinc and pork bellies is surging. The question for investors and advisors is not whether there is money to be made in debt, but in which type of debt to invest.

Commodity-linked bonds redefine the concept of “security.” Commodities, although volatile, are not usually correlated with stock prices or interest rates. One only needs to look at the past year as an example: while the consumer price index has risen at a low single-digit rate, commodity indices have soared into the mid-double-digit range. For the bond investor who wants to enhance portfolio returns and security, debt that sets returns in commodity trends can reduce total portfolio volatility and, at least for the time being, pay a handsome reward.

Mutual funds that invest in commodity-linked bonds are thriving. Frequently cited as an example of the category, Oppenheimer Real Asset A Fund produced a 26.9% average annual compound return for three years ended April 30. Meanwhile, Commodity Real Return Strategy Fund belonging to California-based Pacific Investment Management Co. LLC, one of the world’s largest bond managers, produced a 21.2% average annual compound return for the same period.

Those numbers are moving commodity-linked bonds from a small corner of the market for structured notes into the limelight. But not all financial advisors are comfortable with the concept.

“If the bonds are more complex than our clients can understand, we may be saddled with lawsuits,” says Dan Stronach, who heads fee-only advisor firm Stronach Financial Group Inc. in Toronto. “As advisors, our responsibility is to preserve capital. Unless we have expertise in commodities, we are not willing to accept the risk on their behalf.”

Stronach notes other issues with commodity-linked bonds: “Commodities have certainly been appreciating, but the problem is commodity bonds are an expensive way to participate in the commodity price rally. Many are styled as principal-protected notes, with substantial fees going to the underwriter and the manager. I prefer investors separate their asset classes and invest directly in each asset class. It’s more transparent and less expensive to keep things separate.”

Despite warnings about the risks of bonds linked to commodities, investment dealers have generated a flood of new issues. Barclays Capital, the investment banking arm of Barclays Bank PLC, is a major player in the issuance of commodity-linked notes and sold 230 structured commodity-linked notes in 2005. In just the first quarter of 2006, it did 85 deals and, says Philippe Comer, director of commodity investor solutions for Barclays in New York: “We expect the number to remain high for the rest of this year.”

Year-to-date, Barclays has sold US$1 billion of commodity-linked bonds, says a company spokesman.

Commodity-linked bonds can be appealing to investors. The current bond market is treading water as it tries to decide if interest rates will be dragged up by the Bank of Canada or start falling when the current bull phase of the expansion ends. Indecision has a price and, not surprisingly, the SC universe bond total return index dropped 0.4% in the first quarter of 2006.

Meanwhile, Comer says, some of Barclays’ commodity-linked bonds rose in the secondary market by as much as 30% year-to-date. Backing the commodity-linked bonds’ strong performance, much of it linked to the Goldman Sachs commodity index, is the underlying performance of the index itself.

This year, the broad GSCI isn’t weighted to follow the hottest commodities. The broad GSCI was up just 7.3% to the end of April, the smallest gain since 2003. But silver is up 48%, copper is up 54% and sugar is up 19% year-to-date. For Canadian investors, there’s also currency risk in buying into the US$-denominated GSCI.

But there are easier ways to live with inflation than buying commodity-linked bonds. Canadian real-return bonds offer a modest base return of about 1.5%-1.7%, plus a quarterly adjustment based on changes in the consumer price index. However, with headline Canadian inflation running at 2.2% at the end of March and core inflation — less food and energy — at 1.67%, the short-term attractiveness of RRBs is limited.

Hoping to combine the relative safety of tracking the CPI with potential commodity gains, Barclays structured a note in January with an AA rating from Standard & Poor’s Corp. on Barclays PLC that’s issued in US$1,000 multiples that pays monthly the greater of zero or the change in the U.S. CPI, then sets repayment of principal on July 11, 2008. At maturity, the bond will pay an amount equal to the denomination times the change in a basket of commodities divided by value at issuance date, which was this past Jan. 12. Repayment of principal is guaranteed; the investor should at least get back 100% of face value.

@page_break@Other Barclays commodity products include a debt instrument priced on April 8 with a three-year term and a payoff based on the Dow Jones AIG commodity index — a basket of 19 physical commodities with caps on the weights of each commodity. At maturity, the bond pays the greater of the original amount invested or the full appreciation of the index in the three-year period. This bond is a direct bet on the index with no intermediate return.

But, in today’s thriving commodities market, there’s a temptation to jump into hybrid bonds. Institutional investors barred from buying commodities can often buy commodity-linked bonds.

And then there is the lore of commodity-linked bonds. In 1973, France issued trésors with 7% coupons and a redemption value linked to the gold price. If France dropped its gold link to the franc, the redemption clause in the bonds’ indenture would be triggered. France did drop the link in 1977 and the bonds, which had originally paid 70 French francs per 1,000 French francs face value, paid 393 French francs beginning in 1980. Those bonds became legends.

So should an investor buy into commodity-linked bonds? “Yes, if the investor understands the product,” says Derek Moran, a registered financial planner who runs the Kelowna, B.C., office of Vancouver-based Macdonald Shymko & Co. “If the bonds don’t even pay interest, the underlying income is being diverted to the issuer or the manager. A lot of these structured products may be called bonds but are really risky commodity plays.” IE



Andrew Allentuck is the author of Bonds For Canadians, published by John Wiley & Sons Canada in 2006.