Yield to call for bonds refers to the return an investor would receive if the bond is called by the issuer before it reaches its maturity date. When a bond is callable, the issuer has the option to buy back the bond from the investor at a predetermined price, known as the call price or call premium, before the bond's maturity date.
Imagine you lend your friend $10, and they promise to pay you back $12 in one year. But there's a twist: your friend has the option to pay you back early, let's say in six months, but they'd only have to pay you $11 instead of $12. In this scenario:
The $10 you lent is like the price of the bond. The $12 you expect to receive after one year is like the bond's face value or maturity value. The $11 your friend can pay you if they decide to pay you back early is like the call price or call premium.
So, the yield to call would be the annualized return you'd get if your friend decides to pay you back early. It helps investors understand their potential return if the bond is called before maturity.
Now, let's use some numbers:
Imagine you buy a bond for $1,000, with a face value of $1,200, and it matures in five years. However, the issuer has the option to call the bond after three years at a call price of $1,050.
Price of bond: $1,000 (what you pay) Face value of bond: $1,200 (what you'll receive if bond isn't called) Call price: $1,050 (what issuer pays if they call the bond early) Time to call: 3 years
If the bond is called after three years, and you paid $1,000 for it, but you receive $1,050 back, your yield to call would be the annualized return you made on that investment.
Callable bonds work in favor of the issuer. They give the issuer flexibility to refinance debt at lower interest rates if market conditions change. However, callable bonds are riskier for investors because there's a chance the bond will be called before reaching its maturity, potentially leaving investors to reinvest their funds at lower interest rates.
