Knowing This Yield Measure Can Help Reduce Your Risk
The yield to call of a bond can be an essential piece of information to a bond investor. However, people often underestimate the yield to call, as they often jump to look at the yield to maturity instead. While yield to maturity is a very important factor when looking at bonds, it is important to recognize that in a callable or redeemable bond it becomes essential to look at the bond’s yield to call.
Similar to yield to maturity, the yield to call uses a call date and call price instead of a maturity and face amount. In other words, the yield to call calculates the yield of a bond that would be earned if the bond were to be called at its call date, rather than at the date of its maturity. Also, like yield to maturity suffers from the assumption that the investor won’t sell his bond before the date of maturity, the yield to call suffers from the assumption that the investor won’t sell his bond before the call date.
So why is yield to call important? Yield to call is important because if the bond is called early, than the original yield to maturity will not matter to the investor anymore. Instead, the yield to call will be your new yield. The yield to call will be less than or greater than your yield to maturity depending on the circumstance. If the bond is trading at a discount, or below its face value, then the yield to call is greater than the yield to maturity. Conversely, if the bond is trading at a premium, then the yield to call will be less than the yield to maturity. Therefore, if there is a chance that the bond will be called, then there is a chance that as a holder of the bond you may receive that possibly unattractive or lower yield. For example, imagine that you have two 10-year bonds with an annual coupon rate. Notice that Bond A is priced at par and Bond B is priced at a premium.
Bond A: Issued On: 12/12/2012, Maturity Date: 12/12/2022, Face Value: $100, Price: $100, Coupon: 6%
This is what Bond A’s yield to calls would be:
|Yield to Maturity||6%|
|Call Date: 12/12/2013||Yield to Call||6%|
|Call Date: 12/12/2015||Yield to Call||6%|
|Call Date: 12/12/2017||Yield to Call||6%|
|Call Date: 12/12/2019||Yield to Call||6%|
Notice that because Bond A is priced at par, or its face value is equal to its price, the yield to calls are equal to the yield to maturity.
Bond B: Issued On: 12/12/2012, Maturity Date: 12/12/2022, Face Value: $100, Price: $110, Coupon: 6%
Now let’s look at what Bond B’s yield to calls would be:
|Yield to Maturity||4.54%|
|Call Date: 12/12/2013||Yield to Call||-3.66%|
|Call Date: 12/12/2015||Yield to Call||2.42%|
|Call Date: 12/12/2017||Yield to Call||3.63%|
|Call Date: 12/12/2019||Yield to Call||4.15%|
As we can see from this example, since Bond B is priced at a premium, its yield to calls are less than its yield to maturity. Its yield to worst, or its lowest possible yield, is -3.66%, as opposed to Bond A with a yield of 6%. Although an investor may have been originally expecting a 4.54% yield on Bond B, the callable feature will most likely result in a rate of return equal to one of the yield to calls. If Bond B had been priced at $150 instead of at $110, then its yield to calls would have been even lower. In other words, the higher the premium is on your bond, the lower your yield to calls will be and the less attractive your return will be. Therefore, if you buy a callable bond at a premium, there is a much higher chance that you will receive this lower yield.
However, keep in mind that you are being compensated for this premium through the higher fixed cash payments or coupons you are receiving. In this example, we are receiving a 6% coupon every year, which is much greater than our yield to calls and our yield to maturity. Also, in this example we notice that the sooner the premium bond is called, the lower its yield to call. If we call the bond in December 2015, we receive a yield of 2.42% which is much less than if we call the bond in December 2017 with a yield of 3.63%. This is because you are receiving less coupon payments if your bond is called sooner than later, which explains why your yield to call is lower than your original yield to maturity.
These various call dates show us that the issuer of the bond has a lot of flexibility because he can call the bond at any time. The main reason why the issuer would call the bond is because of a decline in interest rates. If a company issues a bond and interest rates decline during its maturity, the company will likely want to refinance the bond at a lower rate of interest. The company would proceed to call its current bonds and reissue them at a lower rate of interest. Also, it is important to keep in mind that premium bonds are more likely to be called than discount bonds. This is because usually bonds will become discounts after a rise in interest rates as bond prices decrease. Overall, it is advantageous for the company to issue callable bonds in the first place, even though the issuer has to pay more than the face amount to call in a bond.
Callable bonds can be tricky to navigate through for bond investors. Since the callable feature of a bond is so common in the bond market, it is important to know the different parts to a callable bond that could ultimately affect your yield in the future. Looking at the yield to call and yield to worst of a bond can help you decide which bond has a higher chance of giving you a successful return.
The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.