Yield to Call
by Maestrihave the option of holding the bond until it matured. Therefore, the yield to maturity would not be earned. For example, if MicroDrive’s 10 percent coupon bonds were callable, and if interest rates fell from 10 percent to 5 percent, then the company could call in the 10 percent bonds, replace them with 5 percent bonds, and save $100 $50 $50 interest per bond per year. This would be beneficial to the company,
but not to its bondholders.
If current interest rates are well below an outstanding bond’s coupon rate, then a callable bond is likely to be called, and investors will estimate its expected rate of return as the yield to call (YTC) rather than as the yield to maturity.
Here N is the number of years until the company can call the bond; call price is the price the company must pay in order to call the bond (it is often set equal to the par value plus one year’s interest); and rd is the YTC.
Do you think MicroDrive will call the bonds when they become callable? MicroDrive’s action would depend on what the going interest rate is when the bonds become callable. If the going rate remains at rd 5%, then MicroDrive could save 10% 5% 5%, or $50 per bond per year, by calling them and replacing the 10 percent
bonds with a new 5 percent issue. There would be costs to the company to refund the issue, but the interest savings would probably be worth the cost, so MicroDrive would probably refund the bonds. Therefore, you would probably earn YTC 4.21% rather than YTM 5% if you bought the bonds under the indicated conditions.
In the balance of this chapter, we assume that bonds are not callable unless otherwise noted, but some of the end-of-chapter problems deal with yield to call.
Taken From : Five-Minute MBA – Corporate Finance
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