Yield to Call

Definition

Yield to call is a financial metric that indicates the return an investor can expect to earn if a callable bond is redeemed by the issuer before its maturity date. This measure takes into account the bond's current market price, its coupon payments, and the time until the call date, providing insights into the potential profitability of investing in callable bonds. Understanding yield to call is crucial for assessing investment risks and returns related to bond pricing and yield measures.

5 Must Know Facts For Your Next Test

1. Yield to call is typically higher than yield to maturity when interest rates fall, as issuers are more likely to call bonds to refinance at lower rates.
2. To calculate yield to call, investors need to know the bond's call price, the time remaining until the call date, and the current market price of the bond.
3. If a callable bond is called early, investors may lose out on future interest payments, making yield to call an important factor in assessing risk.
4. The yield to call reflects the investor's return based on anticipated cash flows if the bond is called before maturity, which can differ from yield to maturity.
5. Investors often compare yield to call with yield to maturity to determine the most beneficial investment strategy based on interest rate movements.

Review Questions

• How does yield to call differ from yield to maturity, and why is this distinction important for investors?
  • Yield to call and yield to maturity are both measures of potential returns on bonds, but they differ primarily in their time frames. Yield to maturity assumes that the bond will be held until its maturity date, while yield to call calculates returns based on the possibility that the bond could be redeemed early by the issuer. This distinction is crucial because it affects how investors assess risk and make decisions based on interest rate changes. Understanding both yields helps investors anticipate different outcomes based on market conditions.
• Evaluate how changes in interest rates can impact the likelihood of a callable bond being called and what that means for its yield to call.
  • When interest rates decrease, issuers are more likely to call their callable bonds so they can refinance at lower costs. This increased likelihood affects the yield to call because if a bond is called before maturity, investors will receive their principal back sooner than expected, limiting future coupon payments. Consequently, if an investor anticipates a drop in interest rates, they may focus on the yield to call as an important metric for understanding potential returns and investment risks related to callable bonds.
• Analyze how an investor might use yield to call in conjunction with other financial metrics when making investment decisions in a fluctuating interest rate environment.
  • In a fluctuating interest rate environment, an investor should consider yield to call alongside other metrics like yield to maturity and current yield. By evaluating these together, investors can better assess risk versus return when investing in callable bonds. For example, if yield to call is significantly higher than yield to maturity due to declining interest rates, it may indicate that calling is likely, leading an investor to weigh the benefits of short-term gains against potential future income loss. This comprehensive analysis enables more informed decisions in managing a bond portfolio effectively.

Related terms

Callable Bond: A type of bond that can be redeemed by the issuer before its maturity date at specified call prices.

Current Yield: A measure of the income generated by a bond, calculated as the annual coupon payment divided by the current market price of the bond.

Yield to Maturity: The total return expected on a bond if it is held until it matures, considering all coupon payments and the difference between the purchase price and par value.