Work out both yield to worst and yield to call
The idea
For a callable bond, yield to maturity describes only one of several possible outcomes. A yield to call is computed for each call date, using the call price as the redemption amount and the call date as the horizon. Yield to worst is the lowest of yield to maturity and all the yields to call, and it is commonly used as the conservative figure when comparing bonds with call features. When a callable bond trades above its call price, the yield to the first call date is usually the worst and the relevant one, because that is the outcome an economically rational issuer will choose.
A practice question
What is yield to worst?
- The yield assuming the issuer defaultsWhy not: Default is not one of the outcomes being compared — every scenario in the set assumes the issuer pays. What varies is when.
- The lowest of the yield to maturity and all yields to call — correct
- The yield on the lowest-rated bond in a portfolioWhy not: It is a measure for a single bond with multiple redemption dates, not a portfolio statistic.
It takes the least favourable of the outcomes the issuer can choose, which is the prudent figure for an investor to plan on.
A harder one
What redemption amount is used when computing a yield to call?
- Par value in all casesWhy not: Call prices often begin above par and step down toward it. Using par would misstate what the holder actually receives.
- The bond's current market priceWhy not: The market price is what the bond costs to buy, not what the issuer pays to redeem it.
- The call price applicable on that call date — correct
The issuer redeems at the contractual call price, which often begins above par and declines toward it. Using par would misstate the return.
The hardest tier
A callable bond trades well above its first call price. Which yield is most relevant?
- The yield to the first call date — correct
- The yield to maturity, since calls are discretionaryWhy not: Discretionary, and exercised when it suits the issuer. A price well above the call price is exactly that situation.
- The current yield, since the call outcome is uncertainWhy not: Current yield ignores every redemption scenario, so uncertainty about which one occurs is not a reason to prefer it.
A rational issuer will refinance rather than let the bond trade higher. A price above the call price means the issuer can retire expensive debt cheaply, and planning on the maturity date ignores the decision the issuer has every incentive to take.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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