What it means
A callable bond gives the issuer the right, not the obligation, to repay early at a price fixed in the terms. Issuers use that right when interest rates fall, refinancing expensive debt with cheaper debt, which is exactly when the investor would least like the bond to disappear.
Because early repayment shortens the life of the bond and caps the price it can reach, the sensible investor calculates two numbers: yield to maturity, assuming the bond runs its full term, and yield to call, assuming it is repaid at the first opportunity. The lower of the two is known as yield to worst, and it is the figure most professional investors quote.
The call price is usually set above par, often at par plus one year's coupon in the early years, stepping down towards par as the bond ages. That premium is compensation for the investor losing a high paying asset, though it rarely makes up for having to reinvest at the new, lower rates.
For a company issuing debt, the call feature costs money up front. Investors demand a higher coupon on a callable bond than an equivalent non callable one, so the borrower is effectively paying an insurance premium for the flexibility to refinance later.
A bond can have several call dates, so in practice investors compute the yield to each one and take the worst result. Software does this automatically, but the reasoning still matters when judging whether a high headline yield is real or simply a bond about to be called away.
In practice
Real-world examples.
Example
A wealth manager reviews a client's bond paying an 8% coupon and quoting a headline yield of 7%. Noting the bond is callable in eight months at $1,020 and trading at $1,090, the manager calculates a much lower yield to call and sells before the issuer refinances.
Example
A utility issued callable bonds at a 7% coupon five years ago. With market rates now near 4%, it exercises the call at $1,035 and reissues at 4.2%, saving several million dollars of annual interest across a large debt book.
Example
An insurance company building a portfolio to match long term liabilities screens out callable bonds entirely. The risk that its highest yielding assets vanish precisely when rates fall would leave it reinvesting at rates too low to meet its promises.
Think of it
“Yield to call is return if the bond is called early-yield to first redemption date.
Formula
Calculation
The exact yield to call is the discount rate that makes the present value of the remaining coupons plus the call price equal to today's market price. A widely used approximation is: yield to call = [annual coupon + (call price - market price) / years to call] / [(call price + market price) / 2].
Take a $1,000 face value bond paying a 6% coupon, so $60 a year. It trades at $1,050 and the issuer can call it in 4 years at $1,030. Yield to call = [$60 + ($1,030 - $1,050) / 4] / [($1,030 + $1,050) / 2] = [$60 - $5] / $1,040 = $55 / $1,040 = 5.29%.
If the same bond ran to maturity in 10 years and repaid $1,000, the approximate yield to maturity would be [$60 + ($1,000 - $1,050) / 10] / [($1,000 + $1,050) / 2] = $55 / $1,025 = 5.37%. Because 5.29% is the lower figure, the yield to worst is 5.29%, and that is the return the investor should plan around.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Pinehurst Credit Partners, an invented boutique fund, marketed a portfolio on its 6.8% average yield to maturity and attracted strong inflows during a period of falling interest rates.
Roughly 60% of the holdings were callable within three years at prices barely above the levels the bonds were already trading at. When central bank rates fell by a further point, issuer after issuer called their bonds, and the fund found itself holding cash it could only reinvest at around 4.5%.
The fictional fund's realised return came in almost two percentage points below the yield it had advertised. After an uncomfortable investor meeting, Pinehurst rewrote its factsheets to quote yield to worst alongside yield to maturity and set a limit on how much of the portfolio could sit in bonds callable within two years.
Watch out
Common mistakes.
- Quoting yield to maturity on a bond trading well above its call price, which overstates the return the investor is realistically going to receive.
- Assuming a bond will definitely be called, when issuers only exercise the option if refinancing is genuinely cheaper at that moment.
- Ignoring the reinvestment problem, since being repaid early usually happens exactly when the money can only be put back to work at lower rates.
Questions
People also ask.
When is yield to call lower than yield to maturity?
Typically when the bond trades at a premium to its call price, because early repayment forces the investor to give up that premium sooner.
What is yield to worst?
The lowest of the yields calculated to maturity and to every possible call date, and the figure most professional investors treat as the honest headline number.
Why would an investor buy a callable bond at all?
Because the issuer pays a higher coupon for the privilege, which can be good value if the investor judges a call to be unlikely.
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