Chartered Financial Analyst (CFA) Practice Exam Level 2

What does Yield to Call (YTC) assume about a bond?

1. It can never be called back by the issuer

2. It assumes the issuer can call back the bond at the call date

3. It guarantees a return regardless of the market conditions

4. It is only applicable to corporate bonds

The correct answer is: It assumes the issuer can call back the bond at the call date

Yield to Call (YTC) measures the return an investor can expect to earn if a callable bond is redeemed by the issuer at its call date, rather than at its maturity. This metric assumes that the issuer will exercise their option to call the bond when it is advantageous for them, typically when interest rates fall and the bond's coupon rate is higher than current market rates. Therefore, the YTC calculation reflects the potential scenario where the bond is called before its maturity, allowing investors to understand the returns they may receive under those circumstances. The assumption inherent in YTC is crucial because it affects bond pricing and investor expectations, especially for those considering purchasing callable bonds. Callable bonds often have higher yields than non-callable bonds to compensate investors for the call risk, reflecting the possibility that if interest rates drop, the bond may be called back early by the issuer. This return expectation significantly informs investment decisions and portfolio management strategies concerning callable bonds.