What is Yield to Worst (YTW)?
The yield to worst (YTW) can be defined as the minimum yield that can be received on a bond, assuming the issuer doesn’t default on any of its payments. YTW particularly makes sense for bonds where the issuer exercises its options like calls, prepaymentsPrepaymentsPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.read more, or sinking funds.
It is estimated by taking all possible scenarios under consideration where the bonds may be retired before maturity. A YTW estimate gives the investors a fair idea of how their future income may be impacted in the worst scenario and what they can do to hedge any such potential risks.
Yield to Worst (YTW) Calculation
Theoretically, Formula to calculate yield to worst has two broad components:
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For eg:
Source: Yield to Worst (YTW) (wallstreetmojo.com)
- YTW itself is one of the three yield metrics used in the bond market, yield-to-maturity, and yield to call being the other two. Yield-to-maturity is the rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more received assuming the bond is held until expiration, and the issuer doesn’t default, while yield to callYield To CallYield to call is the return on investment for a fixed income holder if the underlying security, such as a callable bond is held until the pre-determined call date rather than the maturity date.read more is the rate of return realized if the bond is called by the issuer at the call date.
- In the case of callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more, YTW is the lower of the yield-to-call and yield-to-maturity.
Example of Yield to Worst (YTW) Calculation
Assuming you hold a callable bond issued by ABC Inc. The bond has an annual coupon rate of 6%, $1,000 par value, and maturity of 4 years. The bond is currently priced at $1,020 and has a 2-year embedded call option.
#1 – Calculating Yield to Maturity (YTM)
Price of bondPrice Of BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more = Coupon1/ (1+y) 1 + Coupon2/ (1+y)2 + Coupon3/ (1+y)3 + Coupon4/ (1+y)4
1020 = 60/(1+y) 1 + 60/(1+y)2 + 60/(1+y)3 +60/(1+y)4
The value of y can be calculated using a financial calculator.
Inputting N=4, PMT=60, PV= -1020. CPT àI/Y
- Where N= no. of periods
- PMT= Payment per period
- PV= Present value (always negative since it is the outflow of money, i.e., a current price that the investor will pay now to buy the bond)
- CPT= Calculate (Command was given to a financial calculator to derive a solution)
- I/Y= YTM
Hence, the value returned by a financial calculator, in this case, will be 5.43%.
#2 – Calculating Yield to Call (YTC)
Calculating YTC the same way we calculated YTM but by inputting N=2 (since the bond is callable in two years,
YTC = 4.93%.
Therefore, the worst-case scenario is that the company will call the bond in two years, and you will realize a yield of 4.93% instead of 5.43%.
Since YTW is lower of the two; it will be 4.93% in this case.
Note:
- If the call price is different from than par value, the current price will be substituted by call price.
- If a bond has more than one call date, YTW is the lowest of YTC, and YTM is calculated for each call date.
- For a non-callable bond, YTW is essentially the same as YTM.
Advantages
Callable bonds favor the issuer rather than the investor. In the event of declining interest rates, companies often choose to exercise their call option so that they can refinance their debt at lower rates, leaving the investor to deal with reinvestment riskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity.read more.
- YTW calculation is very crucial for investors since it gives them a balanced idea of what to expect in the future.
- YTW calculation is especially important in high yield markets where a bond is trading above its face value.
- This metric may make some investors wary of callable bonds, but there is no negative aspect to this measure. Investors are often adequately compensated for the call ability features embedded in the bond, and YTW makes then more prepared to face the uncertain future.
Limitations
- YTW calculations are irrelevant for zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more since there are no periodic coupon payments and are mostly sold at deep discounts to par value.
- No matter how clearly the YTW is stated, there is no assurance that the actual cash flows will be similar to the calculation of the one during YTW estimation.
Conclusion
YTW evolved as a necessary upgrade over YTM and YTC, but its usage remains restricted due to a number of reasons, including the uncertain cash flows over longer durations. It is, however, still considered as a useful measure of credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, and YTWs of all bonds in one portfolio can be utilized to present a unified picture for hedging purposes.
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