Bryant has taught graduate finance and has an MBA and master's degree in information technology.
What Are Bonds?
Susan has been researching different types of investments and decides she will buy some bonds. Bonds are debt securities where an investor lends an initial amount of money, called the principal or par value, to a corporation for a set amount of years. Over those years the investor receives annual coupon payments, which are payments based on the interest rate of the bond. At the end of the set amount of years the investor gets the principal amount back.
Some of the bonds are listed for sale at a premium, which is a bond price that's higher than the par value. Some are listed for sale at a discount, which is a bond price that is lower than the par value. No matter what the bond price is when Susan buys it, if she holds the bond until it matures, she will receive the par value.
Susan understands that the return she gets on the bond will be partly from all of the coupon payments she receives over time and also any difference she receives between what she bought the bond for and what she gets back for par value when it matures.
One way she can find the return she would get on different bonds is from looking at the yield to maturity, which is a calculation of the total return of a bond based off of what price it was purchased at, what the par value is, and how much will be received in coupon payments before it matures.
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While Susan notices that all bonds have those characteristics in common, there are other features that some bonds have and others don't. One feature she noticed often is a call date. A call date is a specific point in time before a bond's maturity that the bond issuer can pay back investors early. This means that Susan would not get all of the coupon payments that she would have if the bond wasn't paid back until its maturity.
This makes it hard to compare bonds with call dates to those without them, so Susan can't rely on using yield to maturity like other bonds.
Yield to Call
Luckily for Susan, there's another way she can compare bonds with call dates. The yield to call (YTC) is a calculation of the total return of a bond based off of the purchase price, the par value, and how much will be received in coupon payments until the call date.
Susan can calculate the YTC using the following equation,
YTC = (C + (CP - P) / t) / ((CP + P) / 2)
- YTC = yield to call
- C = annual coupon
- CP = call price of the bond
- P = price of the bond
- t = time in years remaining until the call date
Let's say that Susan buys a bond for $950 that has a call price of $1,000 in two years. The bond has a 6% interest rate and an annual coupon of $60. Plugging all of the information into the formula would give Susan:
YTC = ($60 + ($1,000 - $950) / 2) / (($1,000 + $950) / 2) = 8.836%
Now Susan can use the YTC value to compare bonds with call dates against others with or without them.
Let's review. In this lesson we learned bonds are conservative debt securities where investors loan an initial amount, called the principal, for a set number of years and receive an annual coupon payment each year until the principal amount is eventually returned, with a coupon payment being a payment based on the interest rate of the bond.
All bonds are issued at an original par value but can be bought or sold at a premium (meaning more than the par value) or a discount (meaning less than the par value). The yield to maturity is a calculation of the annualized total return of a bond that takes into account all of the coupon payments an investor is due to receive before maturity, as well as any difference between the purchase price of the bond and the par value.
The call date is a specific point in time before a bond's maturity that the bond issuer can pay back investors early. And finally, the yield to call (YTC) is a calculation of the annualized total return of a bond based off of the purchase price, the par value, and how much will be received in coupon payments until the call date.
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How to Calculate Yield to Call (YTC): Definition, Formula & Example
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