Back-Up: An Overview
A backup in bond investors' jargon is a change in a bond's yield and price before it is issued that is detrimental to the company issuing it. 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.
- In the bond market, a backup is a downward change in the yield or price of a bond before it is issued.
- The word backup may also describe a trader's sale of a long-term bond in order to buy a shorter-term bond to take advantage of a change in interest rates.
- A short-term price reversal in the markets may also be described as a backup.
Understanding a Backup
A backup damages a company's effort to raise cash to invest in the business.
For example, if interest rates increase, the required yields on most bonds rise with them. This forces a company to either raise the coupon on its bond issue, which increases its interest payments, or sell the bonds at a discount, which reduces the amount of cash it will get from the sale.
In the bond market, a backup occurs when yields rise and prices fall. Yield is the return paid on an investment and is generally expressed as the interest rate paid on the bond. When yields rise their rate of return rises. More money is paid out in dividends while the price of the bond decreases.
Other Financial Definitions of Back-Up
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 tactic is often used when short-term interest rates are more favorable than long-term rates. The newly-acquired bond will result in a more favorable yield than the one that was sold.
Alternatively, a short-term price trend in a market may be described as a backup. For example, the market may be generally moving in a bullish direction. That is, it's gaining overall. But it can then experience a brief bearish reversal before turning around. This short-lived trend, upward or downward, may be referred to as a backup.
Interest Rates in the Bond Market
Bonds are generally less risky than other investment options, especially if they are rated highly by the major bond rating agencies.
However, they do carry risks, 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, the prices for existing bonds fall. This occurs because those older bonds have lower interest rates than newer bonds issued at the current, higher interest rate.
To bond investors, who buy them for their regular payments of interest and do not trade them on the secondary bond market, the risk is different. It is an opportunity risk. 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.