Yield to Call

Publication Date :

22 Aug, 2019

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Table Of Contents

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 ratio 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 bonds 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.

What is Yield to Call?

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 bond 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)

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 debt. 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 (YTM) 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 income 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 calculations.
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 refinancing 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)

Is yield to call the same as yield to worst?

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.

Is yield to call higher than yield to maturity?

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.

Why is yield to call essential?

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.