In the history of bond investing, few issues have turned out as well for investors as the 1973 French Trésors, which had a 7% nominal coupon and a redemption value indexed to the value of a one-kilogram bar of gold. The gold valuation was to go into effect if the French franc lost its parity with the metal.

In 1977, France had to let the franc float. The next year, the International Monetary Fund abolished the linkage of currencies to the price of gold. Those two moves pulled the trigger on the safeguard clause and reset the bond to the price of gold. Beginning in 1980, the government of France has paid 393 francs in annual interest for every 1,000-franc face value bond instead of the 70 francs originally planned.

What happened with the French bonds — often called Giscards in memory of former French president Valéry Giscard d’Estaing, during whose term as minister of economy and finance from 1969 to 1974 they were created and marketed — can happen with other commodity-linked issues if the price of the commodity to which the bond is linked zooms up in price. Other “gold linkers” have been issued by Canada’s Lac Minerals Ltd. (bought by Barrick Gold Corp. in 1994), the Reserve Bank of India, the Bank of England and the Government of Argentina. Bonds linked to the price of oil have been issued by Inco Ltd. and Cominco Ltd. (which became Teck-Cominco Ltd. in 2001).

Bonds with a commodity valuation mechanism appeal to investors who want commodity exposure but appreciate the essential bond idea that, at maturity, the instruments will not pay less than face value. The problem with pricing a commodity-linked bond is that it is very hard to value by either determination of duration or conventional credit analysis. The buyer must evaluate the price of the commodity or the value of the index over the life of the bond.

Investors who buy commodity-linked bonds give up some cash interest in exchange for taking a whirl at the designated commodity or index. And corporate treasuries get to pay submarket rates. The concept is nothing new. Indeed, in 1863, the Confederate States of America issued bonds payable in bales of cotton. The Confederacy was short of gold but long on the cotton crop. The engineering of the bond was a natural.

Today, there is as much as US$70 billion of debt issues linked to commodity prices, says Heather Shemilt, a Goldman Sachs Asset Management managing director in New York who heads the company’s commodity index business. About US$45 billion hangs on the sector-weighted Goldman Sachs commodity index, she says. Most are custom-crafted for institutional clients. Some have been designed for wealthy individual investors who have easier access to the bond market than to futures trading, she adds.

The market is primed for retail financial assets linked to commodity plays. Royalty trusts based on oil or gas are thriving. What distinguishes a bond linked to a commodity is the relative certainty of return of principal. In contrast to the royalty trust, really an equity product that has no price floor, the commodity-linked bond has a predetermined value at maturity.

Commodity-linked bonds offer advantages that conventional bonds that just pay interest in cash do not have. Commodities are an asset class separate from stocks and bonds.

Indeed, commodity price increases are part of the definition of inflation. In periods of very high inflation, such as the early 1980s, commodities outperformed equities, bonds and cash. Furthermore, commodities tend to do well during catastrophes, whereas stocks wobble and inflationary expectations decline. We are in such a period now with the GSCI, a widely used reference for commodity-linked bonds; the index is up 60% year-to-date. The index’s weightings on Sept. 15, 2005, were 79.2% energy, 5.6% industrial metals, 1.7% precious metals, 9% crops and 4.5% livestock. Linking to that index provides exposure to the hottest sector in today’s market.

Commodity-linked bonds and related instruments have done well in the past five years, notes John Brynjolfsson, a portfolio manager at Pacific Investment Management Co.
(PIMCO) in Newport Beach, Calif. “There are hundreds of issues outstanding, but they are not actively traded,” he says. “Issuing dealers handle these structured notes as private placements.”

@page_break@There are ways to participate in the market. U.S.-offered Oppenheimer Real Asset A Fund, which holds commodity-linked bonds, produced a 41.2% return for the eight months ended Aug. 31. PIMCO Commodity Real Return Strategy Fund, also a player in this market, has produced a 12.3% return in the same period. In comparison, the Salomon Bros. corporate bond index (in U.S.-dollar terms) has produced a 3.1% return for the first eight months of 2005.

Is it time to buy into a commodity-linked bond, especially as energy and certain materials have had a long and profitable run?

“There is reason to think the real return on commodities will remain at the high end of the spectrum, says Aron Gampel, deputy chief economist with Bank of Nova Scotia in Toronto. “We are at the beginning of a fairly good commodity cycle that reflects a combination of factors of increasing demand. Whether it is for mining or energy, to a great extent the demand curve has shifted but the supply curve has not moved. I think these conditions suggest the cycle has a ways to go.”

Gampel says the commodity connection will work despite the lack of double-digit inflation that was characteristic of the early 1980s. “Inflation itself is modest by historical standards and is not at the tipping point that would force policy-makers to rein in growth or abort the cycle prematurely,” he says. “On the other hand, no one has an accurate map of how large or how deep this cycle will be.”

Commodity-linked bonds for direct retail sale are ready for a comeback, says Harry Koza, a bond market analyst with Thomson IFR in Toronto. “Gold-linked bonds would be hot if they came out right now,” he says. “Retail investors love gold, and the bonds would swap yield for the gold price.

“From an investor’s point of view,” he adds, “even if the gold price fell, you’d get your coupon and the cash value of principal at maturity.” IE