Bonds are a popular investment choice for many people, including those who are just starting to invest. One important aspect of bond investing is understanding the concept of yield to maturity (YTM) and yield to call (YTC). In this beginner’s guide, we will explore what these terms mean and how they can impact your bond investment decisions.

What is Yield to Maturity (YTM)?

The yield to maturity (YTM) is the total return anticipated on a bond if the investor holds it until maturity. In simpler terms, it is the rate of return an investor will receive if they buy a bond today and hold it until it matures. The yield to maturity takes into account the bond’s current price, its coupon rate, and the time left until maturity.

The formula to calculate the yield to maturity is as follows:

YTM = (C + ((F-P)/N)) / ((F+P)/2)

Where:

C = the bond’s annual coupon payment

F = the bond’s face value

P = the bond’s current market price

N = the number of years until maturity

For example, let’s say you purchase a bond with a face value of $1,000, a coupon rate of 5%, and a maturity date in 10 years. If the bond is currently trading at $950, you can use the above formula to calculate the yield to maturity:

YTM = (50 + ((1000-950)/10)) / ((1000+950)/2) = 5.79%

This means that if you hold the bond until maturity, you can expect to earn a 5.79% annual return on your investment.

What is Yield to Call (YTC)?

While yield to maturity calculates the expected return if the bond is held until maturity, yield to call (YTC) calculates the expected return if the bond is called by the issuer before it matures. A callable bond gives the issuer the option to redeem the bond before the maturity date. If interest rates decline, the issuer can call the bond and issue new bonds at a lower interest rate, which saves the issuer money.

The formula to calculate the yield to call is similar to the yield to maturity formula, but instead of using the number of years until maturity, you use the number of years until the bond can be called:

YTC = (C + ((F-P)/N)) / ((F+P)/2)

Where:

C = the bond’s annual coupon payment

F = the bond’s face value

P = the bond’s current market price

N = the number of years until the bond can be called

For example, let’s say you purchase a callable bond with a face value of $1,000, a coupon rate of 5%, a maturity date in 10 years, and a call date in 5 years. If the bond is currently trading at $950, you can use the above formula to calculate the yield to call:

YTC = (50 + ((1000-950)/5)) / ((1000+950)/2) = 10.52%

This means that if the issuer decides to call the bond in 5 years, you can expect to earn a 10.52% annual return on your investment.

Which One to Use?

Yield to maturity and yield to call are both important concepts to understand when investing in bonds. YTM is more commonly used because it assumes that the bond will be held until maturity. However, YTC is also important to consider because callable bonds are often called before maturity. When comparing bonds, investors should consider both the YTM and YTC to determine which investment is the most suitable for their needs.