Q. This is both something you see on a lot of bond charts… and something that’s driving some of the bond selling these days?
A. Yes… a term with a simple and not so simple explanation. Simple one first: yield to worst tells an investor what he can expect in interest payments on a fixed income instrument. Easiest way to think about it is with a callable bond. Let’s say its’ paying 7% and has a 10 year term; but it’s callable after 5 years. In a yield to worst analysis, you assume current rates for similar instruments, let’s say that’s 4%. So if we assume interest rates don’t change, what will the issuer do when it has the right to call?
Q. He’s call the 7% bond in, and issue a new bond at 4%. So the “yield to worst” calculation assumes that’s what happens, I guess.
A. Right… in the worst case, what will the holder get in yield. Btw, if you assume interest rates are at 10%, you assume the 7% bond won’t be called… in that case, the yield to worst is equal to yield to maturity. Similar ideas apply to other kinds of financial instruments, like CMOs, where the mortgage holders will prepay if they can go out and get new mortgages at lower rates.
Q. OK, that’s pretty straightforward. Where does it get tricky?
A. Well, remember that as rates fall, most bonds gain in value. But with a callable bond, that is often less true… because the issuer may start thinking, hey, great, all of a sudden that call feature is very useful… I’ll call the bond and issue a new one at a lower rate.
Q. So in a falling rate environment, callable bonds are worth less than non-callable bonds.
A. Right, and as a result, they are said to have “negative convexity”– and that, by the way, sets up the buzzword “convexity selling”, which is one of the threats to the bond market right now…for another day.