Yield to Call (YTC)
How it works (Example):
P = price of the bond
n = number of periods
C = coupon payment
r = required rate of return on this investment
F = principal at maturity
t = time period when payment is to be received
To calculate the yield to call, the investor then uses a financial calculator or software to find out what percentage rate (r) will make the present value of the bond's cash flows equal to today's selling price.
The big distinction with yield to call, however, is that the investor assumes that the bond is called at the earliest possible date rather than held to maturity. (To run the calculations assuming the bond is held to maturity would be to calculate the yield to maturity).
For example, say you own a Company XYZ bond with a $1,000 par value and a 5% zero-coupon bonds that matures in three years. Also suppose this bond is callable in two years at 105% of par. To calculate the yield to call, you simply pretend that the bond matures in two years rather than three, and calculate the yield accordingly. You should also consider the call price (105% of $1,000, or $1,050) as the principal at maturity (F). Thus, if this Company XYZ bond is selling for $980 today, using the formula above we can calculate that the yield to call is 4.23%.
[Use our to measure your annual return if you hold a particular bond until its first Calculatorcall date.]
Why it Matters:
Although the yield to call calculation considers the three sources of potential return from a bond (coupon payments, capital gains, and reinvestment returns), some analysts consider it inappropriate to assume that the investor can reinvest the coupon payments at a rate equal to the yield to call. The yield to call makes two other tenuous assumptions: it assumes the investor will hold the bond until it is called, and it assumes the issuer will call the bond on one of the exact dates used in the analysis.
The true yield of a callable bond at any given price is usually lower than its yield to maturity because the call provisions limit the bond's potential price appreciation -- when interest rates fall, the price of a callable bond will not go any higher than its call price. This is because the issuer should act in the best interests of the company and call the bond as soon as it is favorable to do so.
As a result, investors usually consider the lower of the yield to call and the yield to maturity as the more realistic indication of the return an investor will actually receive on a callable bond. Some investors go a step further and calculate the yield to call not just for the first call date, but for all possible call dates. Then the investor compares all the calculated yields to call and yields to maturity and relies on the lowest of them, called the yield to worst.