SERIES 65 | FINANCIAL REGULATION COURSES
Yield to call — abbreviated YTC — is the annualised rate of return an investor would receive if a callable bond is purchased at its current market price, all coupon payments are received as scheduled through the call date, and the bond is redeemed by the issuer at the call price on the first call date rather than held to its stated maturity. Yield to call is applicable only to callable bonds — bonds that give the issuer the contractual right to redeem the bond before its stated maturity date at a specified call price, typically at or slightly above par value — and is irrelevant for non-callable bonds whose only redemption event is the contractual maturity. The yield to call is calculated using the same mathematical framework as yield to maturity — it is the internal rate of return that equates the bond's current market price to the present value of all cash flows the investor would receive if the bond is called on the first available call date — but it substitutes the call date for the maturity date and the call price for the par value in the calculation. Yield to call is a critical analytical tool for investors in callable bonds because issuers call bonds when it is advantageous for them to do so — specifically when interest rates have fallen below the bond's coupon rate and the issuer can refinance at lower cost — which is precisely when the investor least wants to be called because they must reinvest the returned principal at the lower prevailing rates. Yield to call is directly tested on the Series 65 examination in the context of callable bond analysis, the comparison with yield to maturity, and the concept of yield to worst.
Callable Bonds and the Call Feature — Reinvestment Risk and Yield to Call
A callable bond contains an embedded call option that belongs to the issuer — the issuer holds the right but not the obligation to redeem the bond before maturity by paying the bondholder the call price. This embedded option creates a fundamental asymmetry between issuer and investor — the issuer will exercise the call option when it benefits the issuer, which is almost always when it harms the investor.
The primary motivation for calling a bond is interest rate refinancing — when market interest rates have fallen substantially below the bond's coupon rate, the issuer can call the outstanding bonds and issue new bonds at the lower prevailing rate, reducing its annual interest cost. A corporation that issued ten-year bonds at a seven percent coupon five years ago, when the current market rate for comparable credit is four percent, will strongly consider calling the bonds — paying bondholders the call price — and issuing new five-year bonds at four percent, saving three percent annually on the outstanding principal.
This refinancing motivation means that calls occur in declining rate environments — exactly when the reinvestment outlook for bondholders is most unfavourable. The bondholder who purchased the seven percent bond anticipating seven percent income for ten years receives their principal back after five years and must reinvest at four percent — surrendering three percentage points of annual income for the remaining five years compared to the original expectation. The yield to call calculation quantifies this disadvantage by measuring the actual return if the call occurs rather than the return assuming maturity.
The YTC Calculation — The Formula Framework
The yield to call calculation is conceptually identical to the yield to maturity calculation — it finds the discount rate that makes the present value of all cash flows the investor would receive if the bond is called on the first call date equal to the bond's current market price.
The cash flows for YTC calculation are all coupon payments from today through the first call date — not through maturity — plus the call price received at the first call date rather than the par value received at maturity. If the call price differs from par — most commonly at a small premium such as one hundred and two percent of par — this call price premium adds to the YTC relative to a YTM calculation using only par.
The approximation formula for YTC follows the same structure as the YTM approximation formula with the call date substituted for the maturity date and the call price substituted for par value.
Approximate YTC equals the annual coupon plus the quantity call price minus market price divided by years to call date — all divided by the quantity call price plus market price divided by two.
A ten-year bond with a one thousand dollar face value and a four percent coupon — paying forty dollars annually — is currently trading at eight hundred dollars. The bond is callable at par — one thousand dollars — after five years. The approximate YTC equals forty plus the quantity one thousand minus eight hundred divided by five — equalling forty plus forty — equalling eighty — divided by the quantity one thousand plus eight hundred divided by two — equalling nine hundred — equalling eight point nine percent.
For comparison the approximate YTM on the same bond equals forty plus the quantity one thousand minus eight hundred divided by ten — equalling forty plus twenty — equalling sixty — divided by nine hundred — equalling six point seven percent. The YTC of eight point nine percent exceeds the YTM of six point seven percent because if the bond is called in five years the investor earns the same two hundred dollar capital gain — from the eight hundred dollar purchase price to the one thousand dollar call price — in half the time, increasing the annualised return.
The Relationship Between YTC and YTM — The Critical Examination Analysis
The relationship between yield to call and yield to maturity varies depending on whether the bond is trading at a discount or a premium — and understanding this relationship is directly tested on the Series 65 examination.
For a discount bond — market price below par value — the yield to call typically exceeds the yield to maturity. The reason is that the capital gain the investor captures — from the discounted price to the call price at or near par — is earned in fewer years if the bond is called early, increasing the annualised rate of capital gain and therefore the total annualised return. As demonstrated in the example above, the discount bond's YTC of eight point nine percent exceeds its YTM of six point seven percent because the same absolute gain is compressed into a shorter period.
For a premium bond — market price above par value — the yield to call is typically below the yield to maturity. The reason is that the capital loss the investor suffers — from the premium price down to the call price at or near par — is suffered in fewer years if the bond is called early, accelerating the annualised rate of capital loss and reducing the total annualised return. A bond trading at eleven hundred dollars with a four percent coupon callable at par in five years with ten years to maturity will have a YTC below its YTM because the one hundred dollar loss from eleven hundred to one thousand par is realised in five rather than ten years, compressing the annualised loss.
Premium callable bonds present the most significant call risk — investors who purchase callable bonds at premiums above par face the combined disadvantage of capital loss if called and the loss of the above-market coupon that motivated the premium purchase. FINRA Rule 2330's requirement that registered representatives evaluate the cost of surrendering an existing variable annuity or bond contract when recommending a replacement reflects the same principle — the investor who surrenders a premium-priced holding for a new one faces real costs that must be weighed against any benefits of the replacement.
Call Protection — The Non-Call Period
Most callable bonds include a call protection period — also called the non-call period or the lock-out period — during which the issuer cannot call the bond regardless of how far interest rates have fallen. The first call date is the earliest date after which the issuer may exercise the call option — bonds are frequently designated as NC-5 meaning non-callable for five years, NC-7 meaning non-callable for seven years, and so on.
The call protection period provides investors with a minimum holding period during which they can earn the stated coupon without reinvestment risk from early redemption. The longer the call protection period, the more valuable the bond to investors because they have more certainty about the duration of their high-coupon income stream — which is why bonds with longer call protection periods typically carry somewhat lower yields than bonds with shorter or no call protection.
Examination Relevance and Key Takeaways
Yield to call is tested on the Series 65 examination in the context of callable bond analysis, the comparison with yield to maturity, and its role in the yield to worst calculation.
The key points to retain are these.
Yield to call is the annualised return on a callable bond assuming it is purchased at the current market price and redeemed by the issuer at the call price on the first call date. YTC applies only to callable bonds — bonds where the issuer holds the contractual right to redeem before maturity. The YTC calculation uses the same IRR framework as YTM but substitutes the call date for the maturity date and the call price for par value. Issuers call bonds when interest rates have fallen below the coupon rate — when refinancing at lower cost is advantageous — which means calls occur precisely when reinvestment is most disadvantageous for bondholders.
For discount bonds YTC typically exceeds YTM — the same capital gain is realised in fewer years increasing the annualised return. For premium bonds YTC typically is below YTM — the same capital loss is realised in fewer years decreasing the annualised return. Call protection — the non-call period — is the minimum holding period before the issuer may exercise the call option, typically designated as NC-5 or NC-7 for five or seven years of call protection. The call price is typically at or slightly above par — the call premium provides modest additional compensation to bondholders for the reinvestment risk of early redemption. YTC is one of the inputs into the yield to worst calculation — the lowest yield among YTM and all possible YTCs — covered in the following entry.
