The Difference Between Yield to Call and Yield to Worst
Essential information about return rates on callable bonds
Although the yield on most bonds is measured by their yield to maturity, there are two other measurements for yield: yield to call and yield to worst.
Yield to Call
To understand yield to call (or YTC), it’s necessary to first 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 bond could be callable 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 it has the ability to refinance the bond at a lower rate when interest rates are dropping. The disadvantage from the buyer's perspective is that because the bond is more likely to be called when interests rates are low, the investor can reinvest the money only at the then-current lower interest rate.
A bond's yield-to-call is the estimated yield an investor receives if the bond is called by the issuer before its maturity. In other words, the issuer pays off the bond at either the first available call date or at some later date prior to the bond's date of maturity. 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 because it's unlikely to continue trading until its maturity.
The question is, how do you know which yield figure to use?
Yield to Worst
The rule of thumb when evaluating a bond is always to use the lowest possible yield. This figure is known as the “yield to worst." This leads to the next question. How can you tell which is lower, yield to maturity, or yield to call?
If a 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. Let's say a bond is maturing in 10 years and its yield to maturity is 3.75 percent. The bond has a call provision that allows the issuer to call the bond away in five years. When it's calculated for the bond maturing on the call date, the yield is 3.65 percent. In this case, 3.65 percent is the yield-to-worst and it's the figure investors should use. Conversely, if the yield to maturity were the lower of the two, that would be the yield-to-worst.
Determining the Return on Investment
What matters most when you're comparing callable bonds is the actual return on investment when it's called. Determining that return is best done with a financial calculator or any one of several online yield-to-call calculators. You'll have to plug some variables into the calculator, which will then output the actual return on investment. Here's an example:
- Face value: $10,000
- Annual coupon rate: 7 percent
- Years to call: Five
- Coupon payments/year: Two
- Call premium: 102 percent
- Current bond price: $9,000
A yield-to-call calculator will output the result after these figures are plugged in. In this example, the bond's yield to call is 9.9, which is the actual return on investment if the bond is called on the first available date.
Note that the investor receives a premium over the coupon rate – in this case, 102 percent – if the bond is called. This is often a feature of callable bonds to make them more attractive to investors.