THE DEFINITION OF YTW: WHAT IS IT? The Yield to Worst (YTW) is the minimum potential return that an investor can receive on a bond without the issuer defaulting. It considers scenarios where the issuer might redeem the bond early, for example, through a call provision (Yield to Call – YTC). It is the lower of the Yield to Maturity (YTM) and the yield to each potential call date (YTC). For bonds trading at par or below par, the YTW is generally equal to the YTM, as holding the bond until maturity represents the “worst-case” scenario (excluding default). When a bond is discounted, the investor benefits from holding it until the full principal repayment. For premium bonds, the YTW is usually the Yield to Call, as the issuer is more likely to call the bond if interest rates have decreased. Issuers will try to refinance at lower rates if possible.
THE RELATIONSHIP BETWEEN YTW AND EXPECTED FUTURE RETURN FOR HIGH YIELD BONDS For high yield bonds, the Yield to Worst is often considered an indicator of potential future performance. YTW as a forward-looking indicator. The YTW is often considered a reasonable indicator of the potential return that an investor can expect from a high yield bond if held until maturity or the first call date. It represents a “worst-case” scenario for the return, establishing a lower limit for potential returns (excluding default). The YTW provides a conservative estimate of potential income. The reason why YTW is widely used is that historically, the initial yield has been a good indicator of performance over the following three years for high yield bonds. This suggests a correlation between the initial YTW and medium-term returns. The initial level of yield, therefore, captures a significant portion of future returns.
LIMITATIONS OF YIELD TO WORST AS A FORECAST FOR HIGH YIELD BONDS Although the YTW can provide an indication of the minimum potential return, it has several limitations as a predictive tool for high yield bonds.
FACTORS THAT CAUSE DEVIATIONS FROM YTW
Changes in default rates. The YTW does not account for the possibility of default. If an issuer defaults, the actual return will be significantly lower than the YTW. This is a critical limitation for high yield bonds, which have a higher default risk. Market liquidity. Changes in market liquidity can affect bond prices and yields, causing potential deviations from the YTW, especially during periods of market stress. Reduced liquidity can make it difficult to sell bonds at their fair value, impacting realized returns. Market frictions can lead to returns that differ from theoretical yields. Early bond redemptions (Call).
Although the YTW considers the first possible call date, the issuer may choose not to call the bond or may call it on a date other than the first possible one. This would result in an actual return different from the YTW based on the first call. Reinvestment risk. The YTW assumes that coupon payments can be reinvested at the YTW rate, which may not be possible in reality, especially if interest rates decrease. This assumption could overestimate the actual return if reinvestment opportunities at the YTW rate are not available. The return on reinvested income may deviate from the initial bond yield.
Changes in credit spreads: Even in the absence of default or call, changes in the general context of credit spreads can affect the market value of the bond and its total return if sold before maturity. Market sentiment and macroeconomic factors can cause spreads to compress or widen, influencing bond valuations. Market forces outside the issuer’s control can affect bond performance.