Yield to Worst is referred to the lowest possible yield that a bond can generate apart from the company defaulting.
A Yield to Worst will tell you the rate of return if a bond is called before its maturity date. A bond being called simply means a company redeeming the bond before its maturity date.
Now, why is yield to worst important? YTW is one of the crucial points a bond investor needs to be aware of before investing as it presents you with risk in a situation when a bondholder plans to hold a bond till its maturity date. For eg: A bondholder expects a 4% yield to maturity, but if a situation arises where the bond is called by the issuer before maturity date, then the bondholder will receive a yield of 2% instead. Knowing the yield to worst before investing in a bond will allow the investor to make an informed decision. It is not certain that a bond will get called even before maturity, but the yield to worst prepares investors in the case of an eventuality.
What could be the reason for a bond to be called before maturity?
If a situation arises where the interest rates fall below the rates at which the bond was initially issued, the company would want to redeem the bond. For eg: If a bond was issued at a coupon of 6% and at present, the interest rates have dropped to 5%, it is highly probable that the bond issuer will call the bond and reissue at 5 % coupon rate.
You might be wondering, what is the difference between Yield to Worst and Yield to Call as both the parameters give calculations based on the rate of return an investor would receive in a situation where the bond is callable (not all bonds are callable, however, bonds having the call feature can be redeemed by the issuer before maturity)
Well, the difference is the Yield to call refers to the return that a bondholder receives if the bond is held until the call date, which happens a few days before it reaches maturity.
Yield to call can potentially be a higher or lower yield than the yield to maturity, depending on if the bond gets purchased at a premium or a discount to the par value. Whereas, yield to worst will always be lower than the yield to maturity because it is calculated for bonds that get purchased at a premium to par value.
Let‘s put this in an example,
You want to buy a bond that costs Rs 1100 and has a maturity of 10 years. The bond has a coupon rate of 6% which means it will pay Rs 60 as coupon payments annually. The bond has a call option in 2 years but you plan to hold the bond until its maturity date. Now, with the help of a YTM calculator, it is calculated that the YTM will give a rate of return of 4.7%, but if the bond gets called after two years then the bond will be called at its par value i.e Rs 1000. If you had paid Rs 1100 for a bond and you got back Rs 1000 because the bond was called before maturity, you would make a considerable loss. However the coupon payment of Rs 60 each year would have saved you from making that loss as you would make Rs 120 in two years, thus making a profit of Rs 20. By using a yield to worst calculator, we calculate that the yield to worst in is 0.93% if the bond was issued at a premium value, which is a big risk if a bond is called.