What it means
Most bonds run to a fixed maturity date and then repay their face value. A call feature breaks that certainty by giving the borrower an escape route: after a stated protection period, the issuer may redeem the security early at a defined call price.
The terms sit in the indenture, the legal document governing the security, and are set at issue rather than negotiated later. Call schedules usually include a period of call protection, often three to ten years, during which no redemption is allowed.
After that, the call price typically starts above face value and steps down towards par over time. A twenty-year bond might be callable at 103 in year ten, 102 in year eleven and 100 from year fifteen.
The economics are straightforward for the issuer. Calling makes sense when the cost of new borrowing plus the call premium and issuance fees is lower than the cost of continuing to pay the existing coupon.
That is why calls cluster in periods of falling rates and why callable securities are common among utilities, banks and municipal borrowers with long-dated debt. For the investor, the call feature creates reinvestment risk: the money comes back precisely when there is nowhere good to put it.
It also flattens the price ceiling, because no rational buyer pays much above the call price for a security that could be redeemed at that price next quarter. This effect is known as negative convexity, meaning the security gains less when rates fall than it loses when rates rise.
Analysts therefore quote two yields. Yield to maturity assumes the security survives to its scheduled end date, while yield to call assumes it is redeemed at the earliest opportunity.
The convention is to quote yield to worst, which is simply the lower of the two, so that nobody is sold a return that depends on the issuer behaving against its own interests.
In practice
Real-world examples.
Example
A water utility issued $20 million of 7% callable bonds a decade ago, costing $1.4 million a year in interest. It can now refinance at 4.5%, so it calls the bonds at 102, pays a $400,000 premium and cuts annual interest to $900,000. The $500,000 yearly saving covers the premium in under a year.
Example
A municipality's callable bonds trade at 101 against a call price of 102. A portfolio manager notices the price barely moves as rates fall further, because the market has already concluded the bonds will be redeemed at the first opportunity.
Example
A treasury team building a five-year cash ladder deliberately buys only non-callable notes. They are matching known payment dates and cannot risk having capital returned early and having to reinvest it at whatever rate happens to prevail.
Formula
Calculation
Simple yield to call = (Total coupons received to the call date + Call price - Purchase price) / Years to call / Purchase price
Consider a corporate bond with a $1,000 face value and a 7% coupon, paying $70 a year. It is trading at $1,050 because rates have fallen since issue, and the first call date is five years away at a call price of $1,020.
Total coupons to the call date = 5 x $70 = $350.
Loss on redemption = $1,020 - $1,050 = -$30.
Net gain = $350 - $30 = $320.
Average annual gain = $320 / 5 = $64.
Simple yield to call = $64 / $1,050 = 6.10%.
The coupon looks like 7%, but an investor paying $1,050 for a bond that will be redeemed at $1,020 earns roughly 6.10% a year if the call happens on schedule. That 6.10% is the figure to compare against other investments, not the 7% printed on the certificate.Case study
Seen in the real world.
Northbank Community Lenders is an invented institution used for this illustrative example. Eight years ago it issued $60 million of subordinated notes carrying a 6.5% coupon, callable at 102 from year eight, costing $3.9 million a year in interest. At the time, that rate was competitive and the notes counted towards the capital the regulator required it to hold.
By the call date, comparable notes were being issued at 3.9%. Redeeming the old notes cost $61.2 million, including a $1.2 million premium, and issuance costs on the replacement added a further $600,000. The new notes cost $2.34 million a year, a saving of $1.56 million, so the combined $1.8 million of upfront cost was recovered in roughly fourteen months.
In this fictional scenario, the pension funds holding the notes had been modelling income to the original maturity in year fifteen. Their forecasts assumed seven more years at 6.5%, and the call forced them to redeploy $60 million into a market paying far less. The lesson they drew was to value callable holdings at yield to worst from the outset.
Watch out
Common mistakes.
- Comparing a callable security's yield to maturity against a non-callable bond's yield and concluding the callable one is better value. The extra yield is payment for the call risk, not free money.
- Expecting a callable bond to rally strongly when interest rates fall. Its price is anchored near the call price, so most of the potential gain belongs to the issuer.
- Overlooking make-whole call provisions in corporate deals. These allow redemption at any time at a price that compensates the holder, which changes the analysis completely.
Questions
People also ask.
How is a callable security different from a puttable one?
A call is the issuer's option to redeem early, while a put is the holder's option to force early repayment, so the two features favour opposite sides.
Does a call feature always mean the security will be called?
No, it only gets exercised when refinancing is cheaper for the issuer, and in a rising rate environment callable securities often run to full maturity.
What is yield to worst?
It is the lowest yield an investor could receive across all the possible redemption dates, and it is the conservative figure most professionals quote.
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