Yield to Call (YTC) is a critical measure for investors dealing with callable bonds. It informs potential investors of the yield they would receive if the bond issuer decides to call the bond before its maturity date. This article provides insights into the importance of YTC, its calculation, and how it differs from Yield to Maturity (YTM).
What is Yield to Call?
YTC is the internal rate of return on a bond assuming it is called before the maturity date. It accounts for both the bond’s current market price and the total annual coupon payments the bondholder receives until the call date.
Significance of Yield to Call
- Predicting Revenue: It helps investors predict the effective return on their investment if the bond is called soon.
- Risk Assessment: YTC can act as a measure to compare potential returns against the risk of the bond being called.
- Decision-Making: Investors use YTC to determine whether they want to invest in a callable bond or a non-callable one.
How to Calculate Yield to Call
The formula for YTC is similar to the Yield to Maturity (YTM) formula but replacing, in the calculation, the bond’s maturity value and periods with its call value and call date, respectively.
$$
YTC = \frac{Annual \, Coupon \, Payment + \frac{(Call \, Price - Current \, Market \, Price)}{Years \, to \, Call}}{\frac{Call \, Price + Current \, Market \, Price}{2}}
$$
Example
Assume a bond with:
- Face Value: $1,000
- Current Market Price: $1,050
- Annual Coupon Rate: 5%
- Callable in 3 Years at a Call Price of: $1,020
To calculate the YTC:
- Annual Coupon Payment: $50
- Gain from Call: $1,020 - $1,050 = -$30
- Time to Call: 3 Years
$$
YTC = \frac{50 + \frac{-30}{3}}{\frac{1,020 + 1,050}{2}} = \frac{50 - 10}{1,035} \approx 3.86\%
$$
YTC vs Yield to Maturity (YTM)
- YTC considers the scenario where the bond is called prior to maturity. It is relevant when the issuer might call the bond due to potentially dropping interest rates.
- YTM examines the overall yield if the bond is held to maturity. It does not account for any possibility of the bonds being called early.
- Applicability: While YTM is applicable to both callable and non-callable bonds, YTC is exclusively important for callable bonds.
When is YTC Applicable?
YTC is especially vital in periods of decreasing interest rates, as bond issuers have an incentive to call back higher coupon-paying bonds and reissue at a lower rate.
Glossary
- Callable Bond: A bond that can be redeemed by the issuer before its maturity at a specified call price.
- Yield to Maturity (YTM): The total expected return if the bond is held until it matures.
- Coupon Rate: The annual interest rate paid on a bond’s face value.
Additional Resources
Quizzes
Below are quizzes designed to help you test your knowledge on Yield to Call and related concepts:
### Which of the following is true about Yield to Call (YTC)?
- [x] It is used to calculate the yield if the bond is called before maturity.
- [ ] It is applicable to non-callable bonds only.
- [ ] The call price is irrelevant in its calculation.
- [ ] It is the same as Yield to Maturity (YTM).
> **Explanation:** YTC accounts for scenarios where the bond is called before maturity and is relevant only for callable bonds.
### What main difference separates YTC from YTM?
- [x] YTC calculates yield with the assumption the bond will be called.
- [ ] YTM assumes bonds are never paid in interest.
- [x] YTM assumes the bond is held until maturity.
- [ ] YTC does not consider market price.
> **Explanation:** YTC incorporates the call date into yield calculations, whereas YTM assumes holding until maturity without early call risk.
### Which scenario significantly increases the importance of YTC?
- [x] A period of decreasing interest rates.
- [ ] When bond prices are stable.
- [ ] When the issuer is increasing the coupon rate.
- [ ] In times of financial market declines.
> **Explanation:** Issuers are more likely to call bonds in a decreasing interest rate environment to save on interest payments.
### YTC is explicitly used for which type of bond?
- [x] Callable bonds
- [ ] Zero-coupon bonds
- [ ] Convertible bonds
- [ ] Perpetual bonds
> **Explanation:** YTC applies only to callable bonds, which have the option to be redeemed before maturity.
### If a bond is callable in three years, and the interest rates drop significantly, the YTC would:
- [x] Gain increased relevance.
- [ ] Become less significant.
- [x] Reflect earlier potential call.
- [ ] Remain unchanged, irrelevant of conditions.
> **Explanation:** Declining interest rates could lead issuers to call bonds, giving YTC greater practical relevance in assessing yield.
### In bond investment, YTC assists primarily in evaluating:
- [x] Callable bonds' yield if called early.
- [ ] The value of a stock option at expiration.
- [ ] Non-callable bond’s interest rate.
- [ ] The success of equity index futures.
> **Explanation:** YTC evaluates the potential yield on callable bonds if they are called early by the issuer.
### Calculating YTC incorporates which factor?
- [x] The call price of the bond.
- [ ] Only the bond’s face value.
- [x] The market price as of call date.
- [ ] The annual dividend of the bond.
> **Explanation:** YTC calculation involves the bond’s call price and current market price at the expected call time.
### A bond has a $1,000 face and a $1,040 call value, and 5 years to the call date. Its initial YTC calculation assumes:
- [x] YTC based on projected call at that value and date.
- [ ] Only coupon payment without principal.
- [ ] A 10-year maturity without call risk.
- [ ] Use of the total face value only.
> **Explanation:** YTC calculations extend to include the call value and date based on current price and interest rate projections.
### What impacts YTC the most?
- [x] Changes in the interest rate environment.
- [ ] Changes in stock market indices.
- [ ] Corporate earnings reports.
- [ ] Economic recession.
> **Explanation:** Issuers are more likely to call bonds when market interest rates decrease, significantly impacting YTC calculations.
### True or False: YTC provides a likely earnings estimate if the bond reaches maturity.
- [ ] True
- [x] False
> **Explanation:** YTC estimates potential yield if the bond is called, not held to maturity, which differentiates it from YTM.
Summary
Yield to Call (YTC) is an essential tool for evaluating callable bonds within the fixed-income market. By understanding the differences between YTC and Yield to Maturity (YTM), investors can better assess potential yields and the financial implications of callable bonds. Engaging with educational resources, like quizzes and interactive diagrams, can further strengthen your grasp on these topics and prepare you for the Series 7 exam.