Characteristics Of Callable Bonds
Calculation of yield of Callable Bonds
The callable bond price will be lower than that of a straight bond because of this option benefitting to the issuer. However, the yield of a callable bond is higher than the yield of a straight bond. The yield-to-call rate represents the yield rate offered if the issuing company exercises its right to buy back the bond. The call could happen at the bond's face value, or the issuer could pay a premium to bondholders if it decides to call its bonds early.
To compensate investors for the reinvestment risk and unknown final term of investment, callable bonds generally offer higher yields. Investors in callable bonds must consider two yields — the yield-to-call (YTC) and the yield-to-maturity (YTM) — when analyzing the return scenarios of callable bonds. A call schedule is determined at the time of issuance.
An investor buy a bond with a face value of $1,000 and a coupon rate of 5%, so the annual interest payments are $50. The bond matures in 10 years, but the issuer can call the bond for face value ($1,000) in two years if they choose. You buy the bond for $960, a discount to face value.
Given this information, we can calculate the effective yield until the call date as follows: …show more content…
Even by paying higher interest rates the price of a callable bond will not rise much above its call price, no matter how low interest rates are. Taking an example of a 10-year callable bond paying 4% interest. If in five years, interest rates have fallen to 2%, and the issuer calls the bond. Even with slightly higher interest rates like 4.25% or even 4.5% instead of 4% wouldn't fully compensate you for the loss of the last five years of higher interest