Question

In 350 words, discuss the importance of Yield to Maturity and Yield to Call and incorporate real examples where applicable.

Answer 1

Importance of Yield to Maturity and Yield to Call with examples

The Yield To Maturity (Redemption Yield) of the bonds (such as Corporate Bond or T- Bills) is the internal rate of return which investor is going to earn assuming that investor purchase the bond paying price equal to market price and hold the bond until maturity and issuer paid the principal and interest on the bond as per schedule.

Primary importance of yield to maturity is the fact that it enables investors to draw comparisons between different securities and the returns they can expect from each. It’s also useful in that it also allows the investors to gain some understanding of how changes in market conditions might affect their portfolio because when securities drop in price, yields rise, and vice versa. YTM is applicable to the non-callable bond.

• For the Investment analysis and comparison, Yield To Maturity helps the Investors to compare the bonds with different maturities.
• It can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.
• Yield to maturity can be quite useful for estimating whether buying a bond is a good investment. An investor will determine a required yield (the return on a bond that will make the bond worthwhile). Once an investor has determined the YTM of a bond he or she is considering buying, the investor can compare the YTM with the required yield to determine if the bond is a good buy. Because YTM is expressed as an annual rate regardless of the bond's term to maturity, it can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.

For example if a person is evaluating the purchase of a bond and wants to know the yield to maturity...afterall, he wants to hold it until maturity. He knows that the par value is $1,000 and the coupon payment is 5% with the coupon payment being paid annually. That is to say, the bond will pay an annual coupon payment of $50 every year. The market value of the bond is $900 at the moment because the interest rates have risen sharply since the bond was issued.

For this problem, we need to identify the important parts and filter out the noise. The important parts are the cash flows so let's identify those for our YTM calculation. The initial cash flow will be the $900 purchase of the bond. The cash flow for 10 years while the bond is held will be $50 per year. The final cash flow at maturity is the par value or $1,000.  

If we plug that into a yield to maturity calculator we get the yield to maturity equals 6.38 percent. By understanding how yield to maturity works, we could have guessed that the YTM would be higher than the coupon rate of 5 percent.because we bought the bond at a discount to par.

Yield to call is the return on investment for a fixed income holder if the underlying security, i.e., Callable Bond, is held until the pre-determined call date and not the maturity date. The concept of yield to call is something that every fixed-income investor will be aware of. Yield to call applies to callable bonds, which are debt instruments that let bond investors redeem the bonds or the bond issuer to repurchase them on what is known as the call date, at a price known as the call price. By definition, the call date of a bond chronologically occurs before the maturity date.This concept is applicable to the callable bond.

• A callable bond is a debt instrument in which the issuer reserves the right to return the investor's principal and stop interest payments before the bond's maturity date.
• Corporations may issue bonds to fund expansion or to pay off other loans. If they expect market interest rates to fall, they may issue the bond as callable, allowing them to make an early redemption and secure other financings at a lowered rate. The bond's offering will specify the terms of when the company may recall the note.
• The yield to call is widely deemed to be a more accurate estimate of expected return on a bond than the yield to maturity..

Calculating the yield to call on such bonds is important because it reveals rate of return the investor will receive, assuming:

1. The bond is called on the earliest possible date
2. The bond is purchased at the current market price.
3. The bond is held until the call date

For example, if you wanted to calculate the YTC for the following bond.

• Face value: $10,000
• Annual coupon rate: 7%
• Years to call: Five
• Coupon payments/year: Two
• Call premium: 102%
• Current bond price: $9,000

In this example, you'd receive two payments per year, which would bring your annual interest payments to $1,400.

YTC = ( $1,400 + ( $10,200 - $9,000 ) ÷ 5 ) ÷ (( $10,200 + $9,000 ) ÷ 2 )

YTC = $520 ÷ $9,600

YTC = .054, or 5.4%

Note that the investor receives a premium over the coupon rate; 102% if the bond is called. This is often a feature of callable bonds to make them more attractive to investors.