Debt securities with a feature known as "callability" refer to an issuer's right to repurchase the debenture issued before a certain date of maturity. Such a feature is beneficial to the issuer because it provides the flexibility to refinance such debts if a decline occurs in interest rates. For the investors, it creates a reinvestment risk in which they may be forced to reinvest at lesser yields in an event where the bond is called.

Callable bonds have specific relevance in all types of the bond market corporate bonds, municipal bonds, and government securities. Investors should be aware that the evaluation of callable bond yield is different compared to traditional bonds.

Metrics for Callable Bond Yields

A Callable bond must consider more than one yield because they might be called in as early as the maturity date:

1. Yield to Maturity (YTM) is the amount an investor will receive if the bond is kept until the maturity period.

1. Yield to Call (YTC) is the amount he will earn if the bond is called at any point before it matures. 

1. Yield to Worst (YTW) is the minimum amount that could be received by an investor assuming the bond is called at different times.

Understanding these measures is essential for an investor to assess the actual return in money terms from his investment.

Easy Steps to Calculate Callable Bond Yields

1. Gather Important Data

Before calculating, the following are the requirements:

• Face Value (Par Value): The principal amount of the bond, usually one thousand dollars per bond.
• Coupon Rate: The annual interest rate paid by the bond issuer.
• Current Market Price: The price at which the bond is currently trading.
• Call Price: The repurchase price of the issuer for the bond, which is generally a bit above the face value.
• Years to Maturity: The total duration of the bond until it matures.
• Years to Call Date: The period before the issuer can call the bond.

2. Calculate the Yield to Maturity

To determine the yield if the bond is held until maturity, compare the purchase price of the bond, annual interest payments, and the last amount received at the maturity date. If bought at a discount, the yield will be greater than the coupon rate; if bought at a premium, the yield will be lesser.

3. Determine Yield to Call (YTC)

For calculating the yield if the bond is called early, consider the current price of the bond, the annual coupons it will receive, and then the call price. Since callable bonds can be redeemed before maturity, the yield may be different from the maturity yield.

4. Compare YTC and YTM

In case the yield to call is very much lower than the yield to maturity, then there is a high possibility of an early calling of the bond, thus creating reinvestment risk to the investor. It is then wise for investors to make the scenario on which scenario is likely before they take the plunge.

5. Think About Yield to Worst (YTW)

Yield to worst is the lowest possible return that an investor can expect considering all early redemption dates. This is used so that the investor knows the least yield he could ever receive from a worst-case scenario given the options.

Here is a Practical Example:

Suppose an investor purchases a callable bond for a face value of one thousand dollars, a coupon rate of five percent, and a market price of nine hundred fifty dollars. The bond has a call price of one thousand fifty dollars, the length of maturity is ten years, and the call period is five years.

It will yield to maturity, using the purchase price, regular interest payments, and the final payout at the time of maturity.

In an early call situation, the yield will be re-computed using a call price rather than a maturity value.

The investor can consolidate these yields and derive a conclusion on whether the bond is a good investment.

The Final Word

Knowledgeable individuals know that they're very healthy investments with callable bond yields. They should check out arguments of otherwise different types of bond market conditions and test if callable bonds fit their risk tolerance and income targets. The same lines help them derive a realistic YTM, YTC, and YTW calculation for adequate assessment of potential returns.