Yield to worst helps in measuring the lowest yield that can be received on a bond, considering the investment is completely operative within its contract’s terms and is not defaulted. The yield to worst is used when a bond has facilities that permit the issuer to close it before maturity. A bond’s callability can lead to its forced closure, given that there are some specific provisions included in the contract.
As such, the yield to worst helps calculate the worst-case scenario for a bond’s yield at the earlier date of maturity. It helps people manage their risks and ensure that their income requirements are met. Review the following section to understand how this metric works and how investors can analyse their yields.
Understanding Yield to Worst (YTW)
A bond’s yield to worst is estimated based on the earlier retirement or call date. It is believed that a principal’s prepayment occurs if the issuer of a bond uses the call option. Prepayment is the return of the principal before the maturity date due to the exercise of a call option
The principal amount is generally returned, and coupon payments are paused after the call. Both the yield to maturity and yield to call have to be calculated to identify the YTW.
A Guide to Calculate the Yield to Worst
Estimating the YTW needs a thorough understanding of the bond’s features and terms. It involves using different scenarios, including the early redemption due to a call provision, holding the bond until maturity, and the potential prepayments. Thus, the following is a step-by-step method of calculating the yield to worst.
Step 1: Gather the Bond Information
First, collect all the important information about the bond including its maturity date, coupon rate, call provisions, par value, and potential prepayment features.
Step 2: Consider the Potential Scenarios
Estimate different scenarios when assessing the bond’s yield to worst. The scenarios may include the prepayment options, assuming that the bond is called immediately, or even holding it until maturity.
Step 3: Calculate the Yields for Every Scenario
Calculate the yield to maturity, the yield to call, and the yield to worst for every case once you have gathered your scenario assumptions and the necessary information.
The formula for YTM is:
Where:
P = Current price of the bond
C = Coupon payment
F = Face value of the bond
n = Number of periods until maturity
The formula for YTC is:
- t = Number of periods until the call date
- CP = Call Price at which the bond can be called
- C = Coupon payment paid out annually
Step 4: Pick the Worst-Case Yield
Once you have calculated all the yields, the lowest calculated across all possible scenarios will be the yield to worst. The worst-case scenario will help you in preparing for any situation.
Wrapping Up!
The yield-to-worst calculation is an important part of the investment since one must always be prepared for any worst-case scenario. If an investor has any callable bond, then they must make this calculation. But remember, callable bonds can be of several types, and you must estimate them. The YTW estimation is related to the terms and conditions of the bond’s contract, so it is also necessary that investors are attentive to the fine print.
FAQs About What is Yield to Worst?
1. Why does an issuer call bonds?
An issuer may call in the bonds if they are not in a position to pay high interest to the investors. Instead, they may choose to issue a bond at a lower interest rate. This occurs when the bond rates are falling, but the bank has outstanding high-rate bonds. Additionally, an issuer might want to call bonds to reduce its overall debt load, improve financial ratios, or respond to changes in credit ratings.
2. Why is the interest rate important when calculating the YTW?
The interest rate plays a vital role in the yield-to-worst calculations since fluctuating rates affect the attractiveness of the bond’s return. So, the bond prices increase with a decrease in interest rates, and it affects the YTW if the issuer wants to call the bond early.
3. How do call dates affect the yield to maturity?
The call dates affect the YTW when the issuer can choose to redeem the bond before the maturity date. If the issuer calls in the bond early, then an investor may not get the interest payments along with a lower overall return.
