Investors often consider yield when assessing the expected return of a bond. Yield to maturity equates the current price of a bond to its coupon structure. However, yield to maturity is only a relevant metric if the investor receives all coupon payments up to a bond’s maturity date. In the case of callable bonds, or bond funds that include callable bonds, yield to worst—or the lowest potential yield—may be a better measure to compare bonds and bond funds.
To understand why yield to worst should be considered when comparing bond funds, it is helpful to review the various types of yield. A bond is a form of debt that governments, corporations, or other entities, such as municipalities, can issue when they require capital. Bonds represent money loaned by investors and borrowed by issuers. In return for the loan, the issuer is obligated to make payments at a specified rate of interest (or coupon) on agreed-upon dates during the life of the bond.1 In the US, most coupons are paid semiannually and can be based on fixed rates or floating rates. When a bond matures, the issuer must repay to the investor the principal of the bond plus the final coupon payment.
While the coupon rate is the annual payout as a percentage of the principal of the bond, yield considers the price the investor paid for the security. For instance, yield to maturity is calculated by finding the discount rate that equates the present value of a bond’s cash flows to its market price. Yield to maturity is often considered to be a more comprehensive measure of the rate of return because it includes more aspects of a bond investment. Yield to maturity factors in the market price of the bond, principal, coupon payment, and time to maturity. Note, however, that yield to maturity assumes the bond will be held to maturity.
For some bonds, the issuer has the option—but no obligation—to call (redeem) the bond, generally at par value plus accrued interest, at any time on or after a specified call date. Consider the example in Exhibit 1, a bond with a par value of $1,000 issued with a 20-year maturity that becomes callable 10 years after issuance. If this bond was issued at par with a 3% coupon, its yield to maturity at issuance would be 3%. After five years, if market interest rates declined to 2%, the market price of the bond would be $1,129, a premium relative to the bond’s par value of $1,000. Yields and market prices are inversely related; as yields decrease, market prices increase. In this example, however, the bond issuer has the option to call the bond before maturity at $1,000. As such, an investor thinking about purchasing this bond in the secondary market should consider the yield to call of 0.39% in addition to the 2% yield to maturity.