A bond’s Yield to Maturity (YTM) represents an investor’s total return earned if the bond is held to maturity. The YTM considers the coupon rate, the current market price, and the time remaining to maturity. It is the rate that equates to the present value of the bond’s future cash flows to its current market price. The calculation of yield to maturity assumes that all interest payments are received from the date of purchase until the bond reaches maturity and that each payment is reinvested at the same rate as the original bond, which may or may not reflect the actual investment environment. The YTM is not a fixed rate and fluctuates with changes in the bond’s market price, which in turn is impacted by factors such as market liquidity, the credit quality of the issuer, and changes in the interest rate environment. The YTM may be useful for investors to compare two or more bonds with similar characteristics but different credit quality or risk levels. For example, comparing the YTM of a corporate bond with similar tenor with a government bond.

A callable bond is one that the issuer can redeem or ‘call away’ before the bond’s final legal maturity date. These can be called at any time, or only redeemed after a fixed period. The reason for callable bonds, particularly if the maturity date is 10 years or longer, is that issuers want the flexibility to pay back bonds early if interest rates are lower at the time of the call date. Tier 2 (subordinated) callable bonds are generally redeemed at par or $100. The call date(s) and any such related items are known upfront, so that investors can assess the risk and return of the investment. In some cases, fixed income securities may not have a maturity date and be perpetual in nature, such as most ASX-listed bank hybrids (Additional Tier 1 or AT1) and their call dates are very relevant for investors to derive a yield.

The Yield to Call (YTC) and Yield to Maturity (YTM) are calculated using the same method, with the key difference the yield an investor receives assuming bond is called at the next call date rather than maturity date. The YTC is more accurate for Tier 2 bonds which have a call date as opposed to Additional Tier 1 bonds which do not have a maturity date and are perpetual in nature. The shorter holding period for Tier 2 based on the call date mean that mathematically YTC will be lower than YTM respectively (notwithstanding that a bond trading above or below par over time may result in a different result for the YTC and YTM). The Australian swap curve is typically upward sloping, meaning that longer-term swap rates are higher than shorter-term swap rates.

The T2 market is typically a wholesale product, structured with a 10-year maturity with a call date in year 5 (and every quarter thereafter), described as 10-year non-call 5 or 10NC5, with no call premium. The historic reason for the 5-year call date is that the major credit ratings agencies – S&P, Moody’s, and Fitch allocate a 50% equity credit to this debt security for the first five years of the bond’s life moving to zero after five years. In recent years we have seen the emergence of 12NC7 and 15NC10 structures, driven by demand from investors seeking longer duration such as pension funds and insurance companies.

To date, there has never been an Australian bank that has failed to call at the call date. Firstly, a failure to call would be seen by capital markets as a strong signal of deteriorating credit quality, with the bank not confident it is able to refinance in the bond market. Secondly, T2 calls are usually exercised because the equity credit provided by the credit ratings agencies moves from 50% to zero after five years. Thirdly, given T2 spreads are typically higher than senior unsecured bonds, there is an economic incentive for the issuer to call whilst they deliver the most benefit for them. Finally, the high reliance on bond capital markets to fund their large yearly capital requirements is a key to exercising a call.

Major bank T2 subordinated debt has several advantages over AT1 paper (or Bank Hybrids) that retail investors have been buying for decades. Firstly, for similar yields to bank shares and AT1, T2 is less risky and ranks ahead of AT1 and/or shares (in a wind-up/insolvency) and has agreed interest coupon payments with a fixed maturity date. Because of these features they typically have less price volatility than AT1 or shares. AT1 are perpetual and distributions are at the discretion of the Board and APRA, and so are not likely to be paid in a time of stress. APRA is proposing a policy change to phase out AT1 as eligible bank capital starting in January 2027 with full implementation by 2032.