Commodity bonds : a risk management instrument for developing countries

DWC-871 2 Commodity Bonds: A Risk Management Instrument for Developing Countries Theophilos Priovolos Division Working Paper No. 1987-12 November 1987 International Commodity Markets Division International Economics Department Economics and Research Staff The World Bank Division Working Papers report on work in progress and are circulated to stimulate discussion and comment. FL Cp   COMMODITY BONDS: A RISK MANAGEMENT INSTRUMENT FOR DEVELOPING COUNTRIES Theophilos Priovolos November 1987 The World Bank does not accept responsibility for the views expressed herein which are those of the author and should not be attributed to the World Bank or its affiliated organizations. The findings, interpretations, and con- clusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed and the presentation of material used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries, or national affiliations.  I I I  - ii - TABLE OF CONTENTS Page I. INTRODUCTION ............ 1 II. WHAT IS A COMMODITY BOND? 3 III. THE DEMAND FOR COMMODITY BONDS. 9 IV. THE OPTIMAL HEDGE .13 V. PRICING OF COMMODITY BONDS .16 VI. THE FINANCING AND RISK MANAGEMENT NEEDS OF DEVELOPING COUNTRIES AND THE ROLE OF VARIOUS RISK-MANAGEMENT INSTRUMENTS .24 REFERENCES...............................................36  I I I  - 1 - I. INTRODUCTION * In the 1980-86 period commodity earnings fluctuations increased and commodity prices declined sharply (in real and in nominal terms), adding to the difficulties of managing the balance sheets of firms in the commodity business. The purpose of this paper is to bring together and review disperse information on a financial instrument that could prove useful in managing the balance sheets of commodity-producing or commodity-using firms: the commodity bond. This instrument is of particular interest to companies that have low operating costs but high debt servicing requirements. 1/ Commodity bonds can also be useful in restructuring debt. By linking commodity earnings with interest expenditures, commodity bonds may reduce the deleterious impact of lower commodity prices and higher interest rates on net worth. 2/ With commodity bonds opportunity gains due to higher commodity prices (above a defined level) can be foregone in exchange for lower interest rates. For the borrower, commodity bonds issued at par represent an instrument with lower coupons than similar corporate straight bonds. For the investor, lower 'A- I acknowledge with many thanks the support of Ron Duncan for his important contribution to this paper; he encouraged me in pursuing this topic and also guided me in putting this paper together. I note also particularly the support of F. Vita, L. Seigel, A. Powell and K. Chang. Many thanks go also to J. Raulin who typed and courageously edited for style this manuscript. 1/ Commodity bonds can be issued by public (governmental) as well as private entities. 2/ Liquidity problems arise when net worth declines (due to lower commodity prices or higher interest rates) indebtedness increases and/or real assets decline.  - 2 - interest receipts during the life of the bond are often compensated by a premium (in addition to the principle) at maturity; they also represent insurance for satisfying future consumption of the commodity in question. Over many years the developing countries highly dependent on exports of primary commodities have been seeking ways of obtaining more stable export prices. For several commodities (oil and bauxite) cartels were formed, while for some others international commodity agreements were negotiated. These efforts have seldom resulted in long-term stability of prices. At the same time, there has been a proliferation of financial instruments which corporations and government bodies--mostly in the industrial countries--have been using to hedge their commodity risk and fund-raising efforts. One of these instruments is the commodity bond. The question arises: can these financial instruments be used in a similar role by developing countries? The following sections review the literature and provide answers to the following questions: What is a commodity bond? What is the nature of the demand for commodity bonds? What is the optimal hedging amount? How are commodity bonds priced? Finally, there is a review of the financing needs of the developing countries and of the contributions to these needs which various financial instruments--including commodity bonds--could make. 1/ 1/ The paper draws heavily from the work of O'Hara (1984) in Sections II and III, Benninga, Eldor and Zilcha (1985), Gemmill (1985) in Section IV, Schwartz (1982) in Section V and C. Handjinikolaou, 1986, "Developments in Financial Markets" mimeo for 1986 World Development Report in the discussion of swaps and options in Section VI.  II. -WHAT IS A COMMODITY BOND? A commodity bond is a financial security in which the return (yield -to maturity) is linked inter alia to the price of its underlying commodity (see O'Hara, 1984). Conventional bonds pay a stated nominal interest rate (coupon) and a stated nominal amount upon maturity (principal). The commodity bond payoff is a stated quantity of a particular commodity. (For example, a US$1,000 face value gold bond may be redeemable at maturity for 2.50 troy ounces of gold). The interim interest payments may or may not be likewise denominated in units of the particular commodity. Some commodity bonds also incorporate an option feature by allowing the holder to receive either the nominal face value or the designated commodity amount at maturity. These commodity bonds are often called commodity convertible or indexed bonds. Some recent commodity bond issues allow the holder to receive the nominal face value and to choose whether to exercise an option to buy (or sell) a certain amount of the designated commodity at a predetermined price (exercise price) at maturity (or at any other predetermined dates during the life of the bond). These commodity bonds are called commodity-linked bonds. It is the quantity-denominated return structure that distinguishes commodity bonds from conventional bonds. With a conventional bond the nominal return is known but the real return is not. In respect of the commodity bond, both nominal and real monetary returns are unknown. The uncertain real return of a commodity bond also differentiates it from an index bond; that is, a bond whose return depends on an aggregate price level index. Index bonds protect the holder from changes in the overall price level while commodity bonds protect the holder from changes in relative price levels. Only if prices in  the price index change by exactly the same amount as that of the commodity price will these financial instruments be identical. Commodity bonds differ from forward contracts. One difference lies in their cash flows. The purchasers of a commodity bond pay the seller at the outset, while in a forward contract no such exchange occurs until the completion of the contract. Further, commodity bonds typically pay interim coupon payments, but forward contracts pay off only at maturity. Forward contracts are primarily short-term agreements. 1/ Commodity bonds are designated as long-term instruments. In a one-period world, a short position in a commodity bond, i.e., issuing a commodity bond, is equivalent to a short position in a forward contract for the commodity plus a short position in a money bond. Similarly, a long (purchaser) position in a commodity bond is equivalent to a portfolio consisting of a long bond and a long forward contract. In a multi-period setting with perfect capital markets, this same relationship holds if both the commodity bond and the money bond are pure discount securities. 2/ Replicating a coupon-bearing commodity bond, however, is more complicated. A long position in a commodity bond is equivalent to a long position in a money bond and a long position in a portfolio of forward contracts selected to match the cash flow of the money bond. These portfolios are dependent on using long-term forward contracts to replicate the commodity bond's quantity payoff. Such long-term contracts are, however, not commonly 1/ Long-term interest and exchange rate forward contracts are being used increasingly in swap arrangements. 2/ See Richard and Sundaresan (1981).  -5- available as investment vehicles. 1/. In-the forward contract both the long and the short sides have unfulfilled obligations. The short promises to deliver a certain quantity of the commodity; the long promises to pay a fixed price for it. By contrast, in a commodity bond the long meets all of its obligations when the bond is issued; only the issuer has an unfulfilled obligation. Similarities and differences exist also between commodity bonds and future contracts. Both securities involve making or taking delivery of a specific commodity at a specified date in the future. Unlike futures, commodity bonds do not trade in organized exchanges. Margin requirements are also an important feature/consideration in futures contracts in contrast to forward or commodity bond contracts. In addition, the cash flow timing is significantly different. Most futures contracts are reversed prior to maturity, and hence, the commodity is seldom actually delivered. In a forward contract and in a commodity bond, however, delivery is more likely to occur. Lastly, futures contracts are also short-term contracts. Therefore, in the absence of long-term forward and futures contracts, commodity, convertible or indexed bonds are unique financial securities. 2/ 1/ Long-term forward contracts do exist in some industries. For example, a nuclear power plant might arrange for delivery of uranium via such a contract. The integrity of each side is crucial and only the most established companies are likely to be involved. See Joskow (1977) for some problems thereon. 2/ A proliferation of commodity bonds could add liquidity in commodity markets. If the straight bond part is separated from the commodity part, the longer-term forward markets could be developed as has been done in the case of interest rate and exchange rate swaps.  -6- A commodity bond could appear also in the financial markets as a straight (or zero) bond with a commodity option/warrant attached to it at the payoff of the principal. The ("call") option gives the right to the bondholder to buy a pre-agreed quantity of the commodity at a pre-agreed price (exercise price). 1/ The option is bound to be exercised if the actual price at payoff is higher than the exercise price. The bondholder could then make a profit by exercising the option and selling the commodity in the spot market. This premium increases the yield to maturity of the bond. Caps and floors also can be established in a commodity bond to constrain the variability of the implied yield to maturity. The market for long-term commodity options could be greatly developed with the proliferation of these instruments. Following are three recent examples of commodity bond issues. During 1980, Sunshine Mining Company, operator of the largest silver mine in the United States, made two US$25 million bond issues backed by silver. Each US$1,000 bond is linked to 50 ounces of silver, pays a coupon rate of 8