Any investor that is looking forward to investing in bonds must have an understanding of the term yield to call. Some bonds are callable meaning that they can be redeemed before the maturity date by the issuer at a call price that is slightly higher than the par value of the bond. Normally, bonds are called five to ten years after the date of issue and these types of bonds are considered as call protected securities. This means they can be redeemed before the maternity date. The date at which the bonds are called for redemption is essentially known as the call date.
Investors are interested in the returns that would have been generated by the bond over the period of investment. The cash flows associated with a bond are usually the initial outflow at the market value of the bond and the later inflows in terms of interest payments and redemption value. These three primary factors determine the yield of a bond. The basic definition is the rate of return that would be earned by an investor if the investor buys a callable bond. The yield to call is the discount factor that results in the future cash inflows to generate a present value that is equal to the market value of the bond.
The yield that occurs once a bond is called is applicable only if the bond is redeemed before the date of maturity. The yield to call calculation has an inherent claim that the investor can reinvest the interest payments at a specified rate. However, this assumption does not hold true in the real world and therefore critics answer that this calculation does not provide the true rate of return for the investors. This calculation also asserts that the bond holder will hold the bond until the call date and the issuer will call the bond at the earliest date possible. However, this may or may not be true.
The yield of a bond is likely to be lower than the yield to call calculated on the basis of redemption value, market value and coupon payments. This is because the issuer has the power to call the bond before the date of maturity and this acts as a barrier for price appreciation. The price of a called bond will not rise above the call price even when market interest rates fall below the coupon rate. This is due to the fact that the organization is likely to redeem the bonds as soon as the market conditions turn favorable. Therefore, although the yield to call calculation provides the rate of return that would be earned by an investor who invests in a callable bond, this calculation is subject to limitations due to inherent claims and nature of the security.