Many bonds are callable, meaning they can be redeemed by the issuer prior to the bond’s maturity. Callable bonds are often issued to protect the issuer of the bond if interest rates fall substantially after the bond is issued. By issuing callable bonds, the issuer can redeem their bonds when interest rates fall and refinance at the lower interest rate level. (you can learn more about callable bonds here).
The expected return of a bond may be significantly different if the bond is called before its stated maturity date. Yield to call reflects the expected return if the bond is called at the earliest possible date.
Why is yield to call different than coupon rate on the bond?
If the market price of a bond never fluctuated, there would be no difference between yield to call and yield to maturity. However, bond prices often fluctuate. Today, most bonds trade at a price that is much higher than the face or principal value of the bond. Why? Because interest rates are much lower now than they were when the bonds were first issued. (you can learn more about why bond prices move here)
When a bond is bought at a price which is above face value, a call will usually result in the buyer having to accept less money than the purchase price of the bond. Bonds that are being called almost always trade above face value, otherwise, the issuer would just buy the bonds on the market for less instead of calling the bond.
Lets say, a buyer bought a bond with following characteristics:
10% coupon rate ($10 interest per year)
Market Price of $105
Callable in one Year For $100
Matures In Two For $100
How will the yield to call be different than the yield to maturity?
Basically, you can think of the yield to call as (the interest earned + (sale price – purchase price) divided by the purchase price of the bond divided by the number of years the bond is held.*
In this case, the yield to call would be ($10 + ($100 – $105)) / $105 / 1 = .0476 or 4.76%
Basicly, you can think of the yield to maturity as (the interest earned + (principal value – purchase price) divided by the purchase price of the bond divided by the number of years the bond is held.*
In this case, the case the yield would be ($20 + ($100 – $105)) / $105 / 2 = .0714 or 7.14%
As you can tell the yield to call is much lower than the yield to maturity. The key idea is that the longer the bond holder has to capture interest on the bond, the less of the impact the loss of value will have.
* The “ands, ifs, and buts” the formula described above is not technically correct. Specifically, because it does not deal with the issue of compounding or that a future losses and gains need to be adjusted for its value in today’s dollars. That said at low interest rates (below 5%) and short-periods of times less than 5 year, the formula works really well.