What Is Yield To Call?
Yield to call (YTC) represents the return that a bondholder will receive if the bond is held up until its call date, which happens before the bond’s maturity. This calculation is pertinent to callable bonds, which permit bondholders to redeem the bonds or allow issuers to repurchase them at a predetermined call price on the call date, occurring before the maturity date.
This return rate is technically the compound interest rate at which the current bond’s price coincides with the present value of its future coupon payments and the call price. Callable bonds are usually called over several years at a slight premium above their face value, aligning with current market rates.
Key Takeaways
- Yield to call applies specifically to callable bonds, enabling investors to redeem or issuers to repurchase bonds before their maturity.
- This yield can be accurately determined using computational methods.
- Bond issuers may opt to call a bond if shifting interest rates make it economical to reissue a new bond under more favorable terms.
- Investors might exercise the call option to cash in and reinvest or utilize the principal.
Understanding Yield To Call
Numerous bonds, including municipal and corporate bonds, are callable. A drop in interest rates may prompt the issuer to settle the existing debt and secure new, lower-cost financing. Calculating the yield to call is crucial as it forecasts the bond’s rate of return, assuming:
- The bond is called at the earliest permissible date
- It is purchased at the present market price
- It is held until the call date
Yield to call is deemed a more precise return rate estimate compared to yield to maturity.
Calculating Yield To Call
The yield to call calculation formula is straightforward:
P = (C / 2) x {(1 - (1 + YTC / 2) ^ -2t) / (YTC / 2)} + (CP / (1 + YTC / 2) ^ 2t)
Where:
- P represents the current market price
- C is the annual coupon payment
- CP is the call price
- t denotes the years left until the call date
- YTC is the yield to call
Given the formula’s complexity, an iterative process is required to solve for YTC manually, although various software programs can seamlessly compute it automatically.
Yield To Call Example
Consider a callable bond with a $1,000 face value and a semiannual coupon rate of 10%. Currently priced at $1,175, this bond has a call option set at $1,100, five years from now. The maturity duration is excluded from this specific calculation.
The setup calculation is:
$1,175 = ($100 / 2) x {(1- (1 + YTC / 2) ^ -2(5)) / (YTC / 2)} + ($1,100 / (1 + YTC / 2) ^ 2(5))
Iteratively solving, the yield to call approximates to 7.43%.
Are Callable Bonds Better Than Non-Callable Bonds?
Investors sometimes favor non-callable bonds because issuers cannot call them before maturity, ensuring a stable return. Hence, non-callable bonds typically offer slightly lower interest than callable ones. Conversely, issuers bear the risk of paying high-interest rates if market conditions shift for non-callable bonds.
Are Most Bonds Callable?
Most corporate and municipal bonds are callable, whereas most U.S. Treasury bonds and notes are non-callable.
What Happens to Callable Bonds When Interest Rates Rise?
Issuers are less likely to call bonds if interest rates rise since reissuing under such conditions is uneconomical. Conversely, declining interest rates incentivize issuers to call existing bonds and issue new ones at a reduced cost.
The Bottom Line
Investing in callable bonds necessitates an awareness of both yield to maturity and yield to call. Yield to call denotes your return if the issuer cancels the issue early. To ensure expected returns to maturity, consider investing in non-callable bonds for guaranteed regular income.
Related Terms: Yield to maturity, Coupon payment, Call price, Face value, Bond maturity date.
References
- Financial Industry Regulatory Authority. “Callable Bonds: Don’t Be Surprised When Your Issuer Comes Calling”.
- Financial Industry Regulatory Authority. “Understanding Bond Yield and Return”.
