Yield-to-Call (YTC) is a financial metric that refers to the potential return an investor can expect if a callable bond is redeemed by the issuer at the earliest call date. Callable bonds are bonds that give the issuer the right to redeem the bond before its maturity date at a predetermined price. The YTC calculation helps investors understand the yield of such bonds if they are called away, thereby typically providing a lower yield compared to holding the bond until maturity.
Understanding the Yield-to-Call Formula
The Yield-to-Call is calculated using the following formula:
where:
- \( C \) = Annual coupon payment
- \( CP \) = Call price (the price at which the bond can be redeemed early)
- \( P \) = Current price of the bond
- \( t_c \) = Number of years until the earliest call date
Types of Callable Bonds
American Callable Bonds
Bonds that can be called at any time after the initial call date.
European Callable Bonds
Bonds that can only be called on a single specified date.
Bermudian Callable Bonds
Bonds that can be called on specified dates, usually on coupon payment dates.
Special Considerations
- Interest Rate Environment: Issuers are more likely to call bonds in a declining interest rate environment to reissue debt at a lower cost.
- Call Premium: Callable bonds often include a call premium, which is an amount above par value that the issuer must pay to call the bond.
- Duration and Convexity: Callable bonds exhibit different duration and convexity characteristics compared to non-callable bonds.
Examples
Assume you purchase a callable bond with the following characteristics:
- Face Value (Par): $1,000
- Coupon Rate: 5%
- Current Price: $950
- Call Price: $1,020
- Years to Call Date: 3 years
Using the formula, the YTC would be:
Historical Context
The concept of callable bonds dates back to the 19th century when bonds were one of the primary means for governments and large corporations to raise capital. Callable features allowed issuers the flexibility to manage their debt portfolios actively, particularly in response to changing interest rates.
Applicability
Investment Considerations
- Higher Yield: Callable bonds generally offer a higher yield to compensate for the call risk.
- Reinvestment Risk: Investors face reinvestment risk if bonds are called during lower interest rate environments.
Strategic Use for Issuers
- Cost Management: Mitigating the cost of debt by calling and reissuing bonds at lower rates can result in substantial savings.
Comparisons
Yield-to-Maturity (YTM)
Yield-to-Maturity represents the total return if the bond is held until maturity, while YTC assumes the bond will be called at the earliest call date.
Current Yield
Current Yield is a simple calculation of annual coupon payments divided by the current bond price, without considering any calls or maturity.
Related Terms
- Callable Bond: A bond that can be redeemed by the issuer prior to its maturity date.
- Coupon Rate: The annual interest rate paid by the bond’s issuer.
- Call Premium: The premium paid by an issuer to call a bond before its maturity.
FAQs
Q1: Why do issuers call bonds?
- Issuers call bonds to refinance debt at lower interest rates, reducing their overall borrowing costs.
Q2: Is Yield-to-Call always lower than Yield-to-Maturity?
- Not always. YTC can be higher than YTM if the bond’s call price and the timeframe to the call date are favorable.
Q3: Can Yield-to-Call be negative?
- Yes, if the bond is bought at a price significantly above its call price and the call date is near, the YTC can be negative.
References
- Fabozzi, F. J. (2012). Bond Markets, Analysis, and Strategies. Prentice Hall.
- Malkiel, B. G. (1996). A Random Walk Down Wall Street. W.W. Norton & Company.
Summary
Yield-to-Call (YTC) is a crucial metric for investors in callable bonds, offering insight into the potential returns should the issuer exercise their option to redeem the bond early. Understanding YTC is essential for making informed investment decisions and managing the associated risks such as reinvestment risk and potential loss of future income. By considering factors such as the interest rate environment and call premium, investors can better navigate the complexities of the bond market.
