Before getting at Yield to Call it’s vital to know what a “callable bond” is.
A callable bond is an option given in the bond issuance to redeem it back at a certain stage before the maturity date.
A call option is carried out after a fixed period. For example, a 30-year tenure bond could be called after 10 years have passed.
Yield to call refers to the return an investor would receive on a bond until its “call date” before the debt matures. Simply, the call option allows the issuer to be flexible with the interest rate.
A drop in those rates gives an opportunity to earn interest higher than the investor would earn if the bond is held until its maturity.
To calculate the Yield to Call (YTC) for a debt instrument following formula is used:
YTC= (Coupon payment + (Call Price - Market Value) / Number of years until call ) / ((Call Price + Market Value ) / 2)
For example, calculating Yield to Call for below bond
- Face Value of Bond = Rs. 10000
- Coupon rate = 7%
- Call protection = Five
- Coupon payment frequency = semi-annually
- Call premium = 102%
- Current bond price = Rs. 9000
Coupon payments= Rs. 1400 annually
YTC = (1400 +(10200 - 9000 ) / 5) / (( 10200 + 9000) / 2)
YTC = 520 / 9600
YTC = 5.4%
An investor will receive a premium of 2% extra if the bond is redeemed at a callable date. Such an attribute makes the callable bond more attractive to the investor.
The yield to call option takes the advantage of an inverse relationship between price and yield of the bond.
The yield to call option can help an investor to refinance its existing bond at a lower interest rate if the market rate is declining.
A drawback an investor can perceive is that since the bond is called when the market interest rate is low, this provokes an investor to reinvest that money at the prevailing low market interest rate.
The basic thumb rule of the Yield to Call option is that:
- If Yield to Call is higher than Yield to Maturity it is in favour of an investor to redeem the bond at the callable date.
- If Yield to Maturity is higher than Yield to Call an investor should hold back the bond until its maturity.
However, Yield to Call option mainly targets three factors of returns to an investor consisting of coupon payments, increase in the capital asset’s value, and reinvestment of that amount.
YTC calculation primarily looks into these factors for fixed income instruments.
Bottom line
Yield to Call turns out to be a useful way for investors to manage the interest rate fluctuations.
YTC is primarily calculated on the first call date, but many investors calculate the yield on the basis of every callable date. This helps the investor derive the worst possible outcome to be known as “Yield to Worst”
However, it is always important to take guidance from experts before making any crucial decisions. Bondskart has a team of experts who could help you every step of the way to ensure you make an informed decision while making your bond investment.
