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Yield to Worst (YTW)

Updated on January 5, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Key Takeaways

  • The Yield to Worst (YTW) represents the lowest possible yield a bond can generate if the issuer fulfills all payment obligations. This metric is particularly beneficial for bonds that involve potential calls, prepayments, or sinking funds.
  • There are three primary methods to calculate bond yield: yield-to-maturity (YTM), yield-to-call (YTC), and another method. YTM is the yield earned if the bond is held until maturity without defaults. YTC is the yield earned if the issuer calls the bond on its call date.
  • YTW is an improvement over YTM and YTC but has limited applicability due to the unpredictability of cash flows. 

Yield to Worst (YTW) Calculation

Theoretically, Formula to calculate yield to worst has two broad components:

YTW Formula
Yield-to-Worst

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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 MaturityCalculating Yield To MaturityThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more (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:

  1. If the call price is different from the par value, the current price will be substituted by call price.
  2. If a bond has more than one call date, YTW is the lowest of YTC, and YTM is calculated for each call date.
  3. 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.

  1. YTW calculation is very crucial for investors since it gives them a balanced idea of what to expect in the future.
  2. YTW calculation is especially important in high yield markets where a bond is trading above its face value.
  3. 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 them more prepared to face the uncertain future.

Limitations

  1. 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.
  2. 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.

Frequently Asked Questions (FAQs)

1. What is the difference between yield to sink and yield to worst?

Yield to sink refers to the yield on a bond if it reaches its sinking fund redemption before maturity. On the other hand, yield to worst is the lowest potential yield an investor can receive from a bond, considering possible scenarios such as early redemption, call options, or other events that may result in the bond’s lowest yield.

2. What is the difference between coupon and yield to worst?

The coupon is the fixed interest rate a bond pays the bondholder, typically expressed as a percentage of the bond’s face value. Yield to worst, however, considers the worst-case scenario for the bond’s yield, accounting for factors like early redemption or call options that may result in a lower yield than the coupon rate.

3. What is yield to worst vs. current yield?

Yield to worst measures the lowest potential yield an investor can receive from a bond, incorporating scenarios such as early redemption or call options. On the other hand, the current yield is a simple calculation of the bond’s annual interest payment divided by its current market price, providing a measure of the bond’s yield based on its current trading value.

Recommended Articles

This has been a guide to Yield to Worst and its definition. Here we discuss the formula to calculate YTW along with example, advantages, and disadvantages. You can learn more about accounting from the following articles –

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