Yield to Call (YTC)

WHAT IT IS:
Yield to call is a measure of the yield of a bond if you were to hold it until the call date.

HOW IT WORKS (EXAMPLE):

To understand yield to call, one must first understand that the price of a bond is equal to
the present value of its future cash flows, as calculated by the following formula:

where:

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 Yield to Call (YTC) Calculator to measure your annual return if you hold a
particular bond until its first call 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.