Companies that want to raise capital may elect to sell bonds. Sinking funds are bond funds designed so that the company regularly repurchases or retires a portion of the outstanding bonds throughout the life of the issue. As such, the yield of bonds in a sinking fund will not be equal to yield to maturity, since some of the bonds will be retired early. The yield-to-average life calculates the expected yield of a fund by using the average number of years that a bond will be outstanding. By using the yield-to-average life, a bond investor can anticipate more accurately his return on a bond investment with a sinking fund requirement.
For example, imagine a company issues bonds to raise $100,000 U.S. Dollars (USD) with a par value of $100 USD and a five-percent coupon that is payable annually. A sinking fund is incorporated into the terms of the bond with a fixed redemption schedule of 20 percent per year at the par value over five years. Armed with this information, an investor can determine that the yield-to-average life for this investment is four percent annually with an average life of three years. The yield-to-average life falls short of the yield to maturity due to the 20 percent early retirement each year.
To perform the calculation for yield-to-average life, the investor first multiplies the percentage redeemed each year by the redemption payment and the number of years invested. At the end of the each year, the corporation redeems 20 percent of the bonds for $105 USD ($100 USD principal + $5 USD interest). According to the formula, percent redeemed X redemption payment X years, the values obtained for each year are 21, 42, 63, 84, and 105 for a total of 315. This total is divided by (21 X five years), or 105, to produce an average duration of three years. At a coupon rate of five percent for three years, bearing in mind the 20 percent reduction in principal per year, the total yield-to-average life is 12 percent or four percent per year.
Yield-to-maturity is the most common form of earnings calculation. A major drawback to yield-to-maturity formula is that it assumes that the principal will be invested at the same interest rate as the redemptions become due. In actuality, this is rarely true. Even if a conventional bond is held to maturity, the actual yield may differ from the yield-to-maturity. The yield-to-maturity, just like the yield-to-average life, is only an anticipated outcome that depends on interest rate fluctuations.