Investing in bonds can be a great way to make extra money with a safer investment than the stock market often offers, but it is not without risk. Understanding concepts like “yield to worst” can help you make the best decisions when purchasing bonds.
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Bonds are debt instruments that entitle the holder to receive interest payments.
Understanding the yield to the worst
Understanding the yield to the worst
Some bonds calculate your return based on the maturity date, but not all work this way. Other bonds may be redeemed earlier by their issuer if circumstances favor it. When this happens, it may be unexpected, but you can account for the potential event by basing your investment strategy on the worst-case return.
Yield to Worst is a calculation that shows the lowest possible return on a bond, assuming the bond does not default completely. These types of bonds often have a higher yield to account for the possibility that they may be called early. Therefore, they can still make sense as an investment assuming worst-case returns.
What types of bonds are affected?
What types of bonds are affected?
Bonds for which the return should be calculated to the worst value are bonds that are callable. This means that there is a provision in the agreement that allows the issuer to repay it early. If they are paid off early you will miss out on certain interest payments, so it is important to read the fine print very carefully.
There are three main types of callable bonds:
- Optional redemption. These bonds have a feature that allows the issuer to repay the bonds after a certain period of time.
- Repayment of sinking funds. When redeeming sinking funds, the issuer is obliged to regularly repay a portion of the bonds (up to 100%) according to a set schedule.
- Extraordinary salvation. Provides the issuer with the opportunity to call its bonds before the maturity date if certain events occur. This can happen if the project the bonds are financing is seriously damaged or destroyed.
Why are bonds called?
Why are bonds called?
In most cases, bonds are called because it makes more financial sense for the issuer to do so than to continue paying high interest rates to bondholders. They don’t necessarily pay off the project financed with the bonds in full, but instead can refinance it through a bond issue at a significantly lower interest rate. This usually happens when bond interest rates fall and an issuer still has many high-yield bonds outstanding.
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However, bonds may also be called under extraordinary circumstances that could pause, modify or terminate a bond-funded project. There are other reasons why bonds are called. Sometimes the bonds should always be paid off gradually rather than on a single maturity date.
How to calculate the YTW
How to calculate the YTW
For some bonds, the yield to maturity is equal to the yield to maturity, but for callable bonds it may be the same as the yield to maturity. It is always the lowest value, either the call yield or the yield to maturity. These formulas are listed below:
YTC = (coupon interest payment + (purchase price – market value) / number of years until termination) / ((purchase price + market value) / 2)
YTM = (Coupon Interest Payment + ((Par Value – Present Value) / Years to Maturity) / ((Par Value – Present Value) / 2)
Just choose the worst outcome and that is the return to the worst. Pretty simple, but it’s important to note that with zero coupon bonds you don’t have to do this because you’re not trying to account for missed interest payments.
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