Yield to Call
In the previous articles, we have studied the concept of yield to maturity. We now know how to calculate the yield on a particular bond. We also know why the calculation of this yield is important. However, it is important to realize that not all bonds are held until maturity. There is a large portion of bonds that are issued in the market which have callable features. This means that if the market interest rate reduces significantly, the issuer has an option to call their old bonds and then raise new bonds at a lower rate. The yield to maturity calculation becomes somewhat irrelevant for such bonds since they are unlikely to exist till maturity. Hence, it is common for investors to calculate yield to call and use that as a proxy for yield to maturity.
In this article, we will have a closer look at the concept of yield to call. We will also try to understand how it impacts the valuation of a bond.
What is Yield to Call?
The concept of yield to call is applicable only to the bonds which have a call feature. Theoretically, it is possible for bonds to be called at any time before their maturity. However, in real life, such bonds do not exist. It is common for callable bonds to have a schedule when these bonds can be called. For instance, it is possible for a bond to be called every five years. Hence, if the maturity is fifteen years, there is a possibility that the bond may be called either at five years or at ten years.
The concept of yield to call assumes that the bond will actually be called by the issuer at the earliest possible date. Hence, the yield i.e. the return provided by the bond is calculated based on such a scenario. Since the yield is calculated till the call date and not the maturity date, it is called yield to call.
Although, theoretically, investors are only supposed to calculate yield to call for the first call date. However, in reality, it is common for investors to calculate the yield to call for all possible call dates. These numbers are usually calculated beforehand and are taken into account while deciding whether or not to purchase the bond.
How is Yield to Call Calculated?
The calculation of yield to all is quite similar to the calculation of yield to maturity. Just like yield to maturity, yield to call is also made up of three parts.
- The first component of the yield to call calculation is the coupon yield. This is calculated by dividing the coupon payment by the purchase price of the bond. Since bonds can be purchased at a premium or at a discount, the yield can be very different from the coupon rate. It is also important to note that most bonds that have callable features pay a higher coupon. This is because the higher coupon is considered to be compensation for the additional risk which the investor is bearing by investing in callable bonds.
- The second component of the yield to call calculation is the redemption price. Now, in most cases, callable bonds have clearly defined rules about the price which will have to be paid to investors in case they call the bond before maturity. For instance, the indenture may clearly state that the issuer will have to pay a premium of 10% on the face value of the bond if they decide to call it. Hence, this additional 10% should also be considered along with the actual purchase price relative to the face value of the bond. The assumption is that the issuer will call the bond on the respective date. Hence, the redemption price must include the additional $10 amount while making the relevant calculations.
- The third component of the yield to call calculation is coupon payments. The model assumes that the coupon payments will also be reinvested at the same rate. However, this assumption is a flaw of the model. This is also the case when calculating yield to maturity. In this respect, yield to maturity and yield to call is quite similar.
Why is Yield to Call Important?
Yield to call is important since it helps investors make several key decisions regarding a bond. Some of these important decisions have been listed below:
- Firstly, in some cases, investors can decide whether or not they want a band to be called. In such cases, the decisions are driven by a comparison between yield to maturity and yield to call. If the yield to call is greater than the yield to maturity, then the bond is called and vice versa.
- Secondly, yield to call helps investors compare the yield being provided by callable bonds on the same level as yields being provided by non-callable bonds. For instance, if a bond pays heavy coupons after the call date, they should not be taken into consideration since there is a high chance that the coupons may not be paid.
The bottom line is that yield to call is a very important metric for callable bonds. This is because yield to maturity becomes irrelevant in the case of such bonds. It is common for bond investors to systematically track this number and use it to make investment decisions.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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