Evaluating a Bond With Yield to Call and Yield to Worst
Although the yield on most bonds is measured by their current yield and yield to maturity, there there is another measurement for evaluating a bond; the yield to call. Yield to maturity and yield to call are then both used to estimate the lowest possible price—the yield to worst.
Yield to call is a calculation that determines possible yields if a bond can be called by the issuer, reducing the amount of money the investor receives because the bond is not held to maturity.
Yield to Call
To understand yield to call (or YTC), it’s necessary first to understand what a callable bond is. A callable bond is one that an issuer—usually a corporation or municipality—can redeem or “call away." In other words, they can pay it off before the bond’s maturity date.
Some callable bonds can be called at any time. Others can only be redeemed after a fixed period. For example, a 30-year callable bond could be called after 10 years have elapsed. Callable bonds typically carry higher yields than non-callable bonds because the bond can be called away from an investor if interest rates fall.
The advantage to the issuer is that the bond can be refinanced at a lower rate if interest rates are dropping. The disadvantage from the investor's perspective is that because the bond is more likely to be called when interest rates are low, the investor would have to reinvest the money at the current lower interest rate.
Calculating the YTC
To calculate the YTC for a bond, its information needs to be used in this formula:
YTC = ( Coupon Interest Payment + ( Call Price - Market Value ) ÷ Number of Years Until Call ) ÷ (( Call Price + Market Value ) ÷ 2 )
For instance, if you wanted to calculate the YTC for the following bond:
- Face value: $10,000
- Annual coupon rate: 7%
- Years to call: Five
- Coupon payments/year: Two
- Call premium: 102%
- Current bond price: $9,000
In this example, you'd receive two payments per year, which would bring your annual interest payments to $1,400.
YTC = ( $1,400 + ( $10,200 - $9,000 ) ÷ 5 ) ÷ (( $10,200 + $9,000 ) ÷ 2 )
YTC = $520 ÷ $9,600
YTC = .054, or 5.4%
Note that the investor receives a premium over the coupon rate; 102% if the bond is called. This is often a feature of callable bonds to make them more attractive to investors.
Be wary of online calculators, as the results you get will be different. In this example, an online calculator showed the yield to call at 9.90%, which is not accurate.
A bond's yield-to-call is the estimated yield an investor receives if the bond is called by the issuer before its maturity.
Yield to Maturity
The yield to maturity is the yield an investor would receive if they held the bond to the maturity date. This is a similar calculation to the yield to call, except that you don't use the call price—the face value is used.
YTM = ( Coupon Payment + ( Face Value - Market Value ) ÷ Periods to Maturity ) ÷ (( Face Value + Market Value ) ÷ 2 )
You then compare the yields and determine which is the lowest.
Yield to Worst
An investor would want to judge the bond based on its yield to call when it's likely to be called away rather than its yield to maturity. This is because it's unlikely to continue trading until its maturity.
The rule of thumb when evaluating a bond is to always use the lowest possible yield. This figure is known as the “yield to worst." To determine the lowest price, compare the two calculations.
If the bond is...
- Trading at a premium to its par value (its price is $105, but its par value is $100) and
- The yield-to-call is lower than the yield to maturity
...then yield to call is the appropriate figure to use. Assume a bond is maturing in 10 years and its yield to maturity is 3.75%. The bond has a call provision that allows the issuer to call the bond away in five years. When its yield to call is calculated, the yield is 3.65%.
In this case, 3.65% is the yield-to-worst, and it's the figure investors should use to evaluate the bond. Conversely, if the yield to maturity were the lower of the two, it would be the yield-to-worst.