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Bond Yield To Call

If a bond is callable, it is very important to be aware of the yield to call. If the investment is called early at a lower price than what you paid, your YTC will be lower. If the call price is higher, then yield is higher.

Usually it is best for call dates to be as far out as possible for an investor. Normally a called bond is an unwanted occurance for an investor. Bonds are usually called when interest rates decline, so an investor will be forced to invest the proceeds elsewhere at lower rates.

Callable bonds are priced to the call date or the maturity date. Bond brokers will price the bond to the call when it's a premium, and price to the yield to maturity when it is a discount bond.

Calling a bond (unless it is trading at par) will affect the investor's yield, because the call is effectively changing the maturity date. The yield to call will move in the same direction as the yield to maturity, but will move further in yield, up or down.

When a bond trades for less than par (at a discount price), the YTM will be higher than the nominal yield (a profit at maturity that must be taken into consideration), and the yield to call (YTC) will be higher than the YTM.

When a bond trades for more than par (at a premium price), the YTM will be lower than the nominal yield (there will be a loss at maturity), and the YTC will be lower than the YTM. For a bond trading at a premium, the order of the yields from high to low is nominal, YTM, and YTC (think it as being in inverse alphabetical order: N, M, C Nominal, Maturity, Call). For a bond trading at a discount, the order of the yields from low to high is also Nominal, YTM, and YTC (again, think it as being in inverse alphabetical order, N, M, C Nominal, Maturity, Call).

Premium and Discount Bonds

The reason for pricing these bonds differently is twofold. A bond is priced at a premium because the Nominal Yield or coupon rate is higher than current interest rates. Since bonds with higher nominal yields will get called first, it makes sense to price the to the call (ytc). It is also the worse case for the investor. If the bond is called early, the investor will lose the premium faster than if it went to maturity. The yield will be lower if the investment is finished early.

Discount bonds will have a higher yield if they were called early vs. pricing them to maturity. They are not priced to the call normally. Discount debt has a lower nominal yield than the market, so they are less likely to see a call date acted on. Discount bonds are priced to a Yield To Maturity.

In the end, it is about risk - reward. Which is the rule of all investments, including bonds. Although the principal is not at risk (minus an unlikely company default), the risk lies with reinvesting your money if the bond is called when interest rates are very low.

Books To Recommend

Bond Markets, Analysis, and Strategies (5th Edition)

The Handbook of Fixed Income Securities

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