In bond investment, the term yield to worst (YTW) denotes the lowest possible amount of interest which can be earned on a callable bond.
Bond coupon payments may increase over its term (see: Step-up bond), or interest may accrue throughout the bond term rather than being paid out as coupons (see: Accrual bond). If a bond is callable, it can be terminated by the bond issuer before it matures. When a callable step-up bond or accrual bond is terminated before its maturity date, the average annual interest earned on the bond will be lower than they would have been had the issuer allowed the bond holder to keep the bond until it matured.
In most cases, callable bonds can only be terminated at predetermined intervals – typically at the end of each year. The YTW of a callable bond shows the interest rate which would apply if the issuer terminated the bond at the earliest possible interval.
Example of yield to worst:
You buy a 1000-Swiss-franc bond which has a 5-year term and a 5% annual interest rate. The bond is an accrual bond, so annual coupons are added to the bond principal and earn interest the following year (compounding interest). The bond is callable at the end of each anniversary year.
If you were to keep the bond for the full 5-year term, you would receive 1276.30 francs (your 1000 francs plus 276.30 francs of interest) when the bond matured. However, if the bond’s issuer terminated the bond on the nearest possible call date 1 year from the time you bought it, you would get just 1050 francs (your 1000 francs plus 50 francs of interest). In this case, the bonds YTW is 50 francs.
The published interest rates from some borrowers are not effective annual interest rates. Instead, they take the highest possible yield you would get if you held the bond until maturity, and they divide it by the number of years in the bond term. Understanding the YTW of bonds is even more important when this method is used, because the “annual interest rate” shown is higher than the interest you would receive if the issuer terminated the bond after 1 year.
See also: Yield to call (YTC), yield to maturity (YTM).
