What is Yield to Call?
Every fixed-income investor will be aware of the concept of yield to call. Yield to call is the return on investment for a fixed income holder if the underlying security, i.e., Callable Bond, is held until the pre-determined call date and not the maturity date. What P/E ratioP/E RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more is to equity, expiry for options, yield to call is to Bonds.
Understandably, this call date is much before the maturity date of the underlying instrument. Not every fixed-income instrument has the concept of a call date. Only callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more have this feature. Since these bonds provide an added feature to investors of redeeming the bond at a call date (at a pre-decided call price), they relatively demand more premium.
Table of contents
Key Takeaways
- The “yield to call” term is well known to all fixed-income investors. It is the return on investment for a fixed-income investor if the underlying instrument is held until the call date rather than the maturity date. Option expiry dates and call yields are equivalent to the P/E ratio in bonds.
- Although yield to maturity (YTM) is a popular measure for evaluating bond returns, the calculation becomes more complex and requires more exact for callable bonds.
- Its computation considers three aspects of an investor’s return. Prospective returns include coupon payments, capital gains, and the amount reinvested.
Components of Yield to Call
To summarize, the yield to call calculations are significant because it helps investors gauge the return on investments; he will be assuming the following factors.
- The bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more is held until the pre-decided call date and not the maturity date.
- The Bond’s purchase price is assumed to be the current market price instead of the Bond’s face value.
- Even though there can be multiple call dates, it is assumed that the bond is calculated on the earliest possible date for calculation purposes.
Yield to Call Formula
The formula for yield to call is calculated through an iterative process and is not a direct formula, even though it may look like one.
Mathematically, yield to call is calculated as :
Yield to Call Formula = (C/2) * {(1- (1 + YTC/2)-2t) / (YTC/2)} + (CP/1 + YTC/2)2t)
You are free to use this image o your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Yield to Call (wallstreetmojo.com)
- B = Current Price of the Bonds
- C = Coupon payment paid out annually
- CP = Call price
- T= Number of years pending until the call date
As explained earlier, Yield to Call is not calculated by directly substituting values. An iterative process needs to be carried out. Fortunately, in the present era, we have computer programs to compute YTC by carrying out the iterations.
Yield to Call Calculation
Let’s take an example of a callable bond that has a current face value of £ 1,000. Assume that this Bond pays a coupon of 10% on a semi-annual basis and has a maturity of 15 years. This bond can be callable for £ 1100 in five years. The current price of the bond is £ 1200. Let’s calculate the yield to call of this callable bond.
Let us list down all the inputs that we have.
| Bond Type | Callable |
|---|---|
| Face Value | 1000 pounds |
| Coupon Payment | 10% |
| Pay Out Frequency | Semi annual |
| Maturity | 15 Years |
| Callable Price | 1100 pounds |
| Callable Date | 5 years |
| Current Price | 1200 pounds |
| Yield to Call | To be calculated |
Since we are calculating yield to call, we are not concerned about the maturity period of 5 years. What matters is five years after which the bond can be called.
Substituting these values in the equation :
£1200 = (£100/2) * {(1 – ( 1 + YTC/2)(-2*5)) / (YTC/2)} + (£ 1000/1 + YTC/2)(2*5)
These values can be fed into a scientific calculator or computer software. Else it can be calculated through an iterative process if done manually. The result should be approx. 7.90 %. This effectively means even though the promised coupon is 10%, if the bond is called before maturity, an investor can expect an effective return of 7.9%.
Important Points of Note
Although yield to maturity (YTM) is a much popular metric used to calculate the rate of returns on the bond, for callable bonds, this calculation becomes a bit complex and might be misleading. The reason being callable bonds provide an added feature of a bond being called by the issuer as per his convenience. Naturally, the issue will look to refinance only when interest rates are low so that he can refinance the principal and reduce the cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more. Hence for a prudent investor, it makes sense to calculate both the parameters and be prepared for the worst case.
- Yield to call (YTC) is calculated as explained above based on the available callable dates.
- Yield to maturity (YTMYTMThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more) is calculated assuming the bond is never called in its lifetime and is held till maturity.
Some Thumb Rules
- YTC > YTM: it’s in the better interests of the investor to opt for redemption.
- YTM > YTC: it’s advantageous to hold the body until maturity.
- Yield-to-call calculation focuses on three aspects of return for an investor. These sources of potential return are coupon payments, capital gains, and the amount reinvested. The whole calculation is on the assumptions around these three important attributes of fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more securities.
- However, most analysts consider the assumption that the investor can reinvest the coupon payments at the same or better rate inappropriate. Also, assuming that the investor will hold the bond until the call date is faulty can lead to misleading results if used for investment calculationsFor Investment CalculationsAn investment calculator computes the amount, including the income earned on the initial amount invested in any investment plan or product which offers compounding earnings.read more.
- The yield of call for any callable bond at any given price until the maturity of the bonds will always be less than the yield to maturity. This is because the provision that the bond can be called leads to an upper cap on bond price appreciation.
- The reason is simple: the issuer will take care of the underlying security and will call it only when it can reissue at a lesser rate of interest. Hence if the interest rates fall, the price of a callable bond will rise but only to some extent compared to a vanilla bond with no upside potential. This is quite logical as bonds should be called only if interest rates fall, and only the refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more will make sense.
Conclusion
Yield to call is one of the prudent ways for an investor to be prepared for interest rate volatility. Although it is calculated based on the first call date, many investors calculate the yield on all dates when the issued security can be called off. Based on that, they decide the worst outcome possible, and this derived yield is called the yield to the worst calculation.
Frequently Asked Questions (FAQs)
Yield to worst measures the lowest potential yield on a bond with an early retirement clause. Taking to the worst is sometimes the same as yield to the call. However, yield to worst must always be smaller than yield to maturity since it reflects a return for a shorter investment term.
Yield to maturity is the total return paid out when a bond is purchased until it matures. The yield to call is the amount paid if the issuer of a callable bond decides to pay it off early. As a result, callable bonds often have a higher yield to maturity.
When the yield to call exceeds the yield to maturity, the bond is called, and vice versa. Second, yield to call allows investors to compare the yields supplied by callable bonds to those provided by non-callable bonds.
Recommended Articles
This has been a guide to What is Yield to Call and its definition. Here we discuss the formula to calculate the yield to call, examples, and its comparisons with Yield to Maturity (YTM). You can learn more about excel modeling from the following articles –
Leave a Reply