Introduction

Commodity-linked securities provide Indian investors a specific way to participate in commodities markets without holding physical assets such as gold, oil, or agricultural products. They provide, therefore, a diversifying investment that may increase portfolio performance, but there is a fair amount of complexity in investing in commodity markets. In this article, we will define commodity-linked securities and review these investments' advantages, risks, and limitations, directed at Indian investors seeking to invest knowledgeably.

Definitions of Commodity-Linked Securities

Commodity-linked securities are financial instruments whose value is related to price changes of commodities like precious metals (gold and silver), energy (crude oil and natural gas), and agricultural products (e.g., wheat, soybeans) and the price movements of underlying commodities. Unlike direct commodity investments that require the storage of these commodities or futures contracts, commodity-linked securities provide indirect exposure through structured investment vehicles. Commodity-linked securities tend to be constructed as bonds, whereas Indian investors usually gain indirect commodity exposure through equities of companies involved in commodity-centric sectors.

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In India, the actual commodity-linked securities are generally the equities of companies with operations heavily reliant on certain commodities. For example, the price of shares of an oil exploration company is also likely to rise. Commodity-linked bonds are not as easy for retail investors to access. Still, they are fundamentally structured debt instruments where either the principal or the interest payments vary according to changes in the price of commodities.

How do Commodity-Linked Securities Work?

Commodity-linked securities come in two primary structures:

Principal-Linked Bonds: The amount repaid at maturity varies with the performance of the underlying commodity. Potentially resulting in gains or losses in principal.

Coupon-Linked Bonds: These bonds have an adjustable interest rate (coupon) linked to the price of a commodity - the principal on these bonds would remain fixed. For instance, a bond with coupons related to the cost of silver would pay a higher coupon if silver prices increased.

Equity securities, on the other hand, represent companies related to a commodity. For example, a mining company may benefit from a rise in gold prices because the higher price will increase both revenue and stock price.

Benefits of Commodity-Linked Securities

Commodity-linked securities provide many advantages for a typical Indian investor:

Exposure Without Ownership: These securities will allow an Indian investor to profit from commodity price changes without worrying about the logistics of storing or trading the product.

Portfolio Diversification: Adding commodity-linked securities to a portfolio adds additional diversity to an investor's portfolio, beyond the typical equities and fixed-income securities route and may also reduce the investor's portfolio risk.

Hedge against Inflation: Commodities such as gold often do well during inflation, so commodity-linked securities have the potential to hedge against rising prices.

Transparency and Regulation: SEBI regulates and supervises securities in India, and equities have specified pricing mechanisms and disclosure of risks.

No Physical Delivery: Like the futures markets, commodity-linked securities do not require physical delivery.

Risks of Commodity-Linked Securities

Commodity-linked securities present unique opportunities but bring with them significant risks:

Price Volatility: Commodity-linked securities are subject to price volatility based on global supply-demand, geopolitical events, and weather events.

Counterparty Risk: For bonds, investors need only be concerned with the issuer's financial strength to withstand these events. However, operational or economic events affecting the company could harm the issuer, leading to investor losses.

Market Risk: Securities linked to equities provide both risks since their prices are influenced by general market events impacting all equities; if equities fall during economic downturns or if a commodity falls, the price effect could be compounded.

Limitations of Commodity-Linked Securities

Investors should consider certain limitations:

Limited Access- In India, commodity-linked bonds are broadly accessible only to institutional investors. Retail investors typically access commodity exposure via mutual funds or stocks of commodity-driven companies.

Liquidity- These securities, especially bonds, historically have low volumes in a secondary market, so exiting the investment before maturity may not be viable.

Regulatory and Tax Implications- Tax policy or SEBI regulation changes can affect returns. Investors should be aware of capital gains tax and applicable rules for general compliance.

Knowledge Barrier- To understand commodity markets, you must be aware of global economic conditions, changes in the supply chain, and policies, which can confuse novice investors.

Conclusion

Commodity-related securities give Indian investors a tactical way to access commodities' potential while diversifying their portfolios. They have advantages like inflation protection and access to commodities without physical ownership, but disadvantages like significant price fluctuations and liquidity issues. These securities can be valuable to any investor's portfolio if they are willing to spend time understanding the process related to investing in the commodity market. Always seek the opinion of a financial advisor to ensure that the security offers the right level of risk according to your investment profile and goals.

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