What Is a Backup?
The term "backup" commonly refers to the detrimental change in a bond's yield and price before it is issued by a company. This term is actually jargon used by bond investors.
The price of a bond backs up when a company finds the security more costly or less lucrative to issue than it had anticipated. A backup is usually caused by an unexpected change in interest rates.
The word "backup" is also used to describe a transaction in which an investor sells one bond to buy another, or it may denote a short-term price trend.
- A backup is trader's slang for an unfavorable change in the yield, spread, or price of a bond before it is issued.
- Usually caused by a change in interest rates, a backup can damage a company's effort to raise cash from the bond issue,
- To compensate, companies need to raise the coupon on their bond issue or to sell their bonds at a discount.
- The word backup may also describe the sale of a long-term bond to facilitate the purchase of a shorter-term bond to benefit from interest rate changes.
- A short-term price reversal in the markets overall may also be described as a backup.
How Backups Work
The term backup is lingo used by bond investors. In the bond market, a backup occurs when yields rise prior to issuance and offering price or coupon (interest) must be adjusted to compensate for the increase in required yield. A yield is the return paid on an investment and is generally expressed as the interest rate paid on the bond. When bonds' yields rise, their rate of return rises. This means that effectively more money is paid out in interest relative to the price of the bond, which decreases. Thus, when yields rise prior to issuance of a bond, the issuer has to decide whether to increase the coupon (interest) rate they are willing to offer bondholders, or lower the price of the bond below par.
For instance, if interest rates increase, the required yields on newly issued bonds will rise with them. This forces a company that has yet to issue bonds to raise the coupon on its bond issue, which increases its cost of debt. The other option is for the company to sell its bonds at a discount and reduce the amount of cash it raises from issuing (selling) the bonds.
In other words, the bond issue has become more expensive. This increase in the cost of issuing the securities—aka the spread, the difference between the amount paid to the issuer of a security and the price paid by the investor for that security—is the backup. A backup essentially damages a company's effort to raise cash to invest in operations or other aspects of the business.
Additional Meanings of Backup
There are a couple of other uses for the term backup in the bond market. A bond trader may sell one bond, generally with a longer maturity, and use the proceeds to purchase another bond, often with a shorter maturity. The transaction is called a backup. This is a tactic often used when short-term interest rates are more favorable than long-term ones. The newly acquired bond results in a more favorable yield for the investor than the one they sold.
A short-term price trend in a market may also be described as a backup. For example, say the stock market is moving in a bullish direction—that is, stock prices are generally on the upswing. But there may be a chance that it experiences a brief bearish reversal before turning back around. This short-lived trend, regardless of whether it goes upward or downward, is often referred to as a backup.
Bonds are generally less risky than other investment options, especially if they are graded highly by the major bond rating agencies. But this doesn't mean they don't come with risks. In fact, carrying bonds may lead to losses for investors in certain situations, particularly in the secondary bond market.
Interest rates are the primary factor in the price of a bond and on its yield. As interest rates rise, existing bond prices fall. This occurs because those older bonds pay less interest than the newer bonds issued at the current, higher interest rates: A bond paying 3% looks less desirable when the prevailing rate has jumped to 3.5%. To compensate for its lower payout, the older bond's purchase price falls—kind of similar to the way last year's BMW or iPhone gets marked down when the new model comes out. This is known as interest rate risk or market risk.
Both interest rate risk and opportunity risk increase the longer you hold a bond, or the longer a bond's maturity. The longer the term of your bond, the greater the chance that a more attractive investment opportunity will become available.
Investors who buy bonds for their regular payments of interest and do not trade them on the secondary bond market don't have to worry about their bonds declining in price. But they do face a slightly different problem, known as the problem is opportunity risk or holding-period risk. This means an investor who buys a long-term bond, risks committing money at a relatively low rate of return if interest rates and bond yields rise for new issues.