What Is Spread-To-Worst?
Spread-to-worst (STW) is the difference between the yield-to-worst (YTW) of a bond and yield-to-worst of a U.S. Treasury security with similar duration. The spread-to-worst either yield-to-call or yield-to-maturity, whichever is lower. The spread is expressed in "basis points" (bps).
- Spread-to-worst is yield-to-worst of a bond less yield-to-worst of a similar duration Treasury security.
- Yield-to-worst is the lower of yield-to-call and yield-to-maturity, which is the lowest yield an investor can receive.
- The yield-to-worst is typically important if a bond has callable features—calling the bond results in a lower return than holding until maturity).
- Callable bonds typically have higher yields than those without call features.
Spread-to-Worst uses the yield-to-worst, which is the lowest potential yield that can be received on a bond without the issuer actually defaulting. If a bond is callable, an investor runs the risk of lower returns from the bond. This is because, in an environment of declining interest rates, the bond investor would have to reinvest in lower-yielding fixed income securities. Corporate bonds and municipal bonds typically have call provisions.
A bond's YTW is calculated on all possible call dates prior to maturity. It is assumed that a prepayment occurs if the bond has a call option and the issuer can reissue at a lower coupon rate. The YTW is the lower of yield-to-maturity or yield-to-call. Yield-to-call is the annual rate of return assuming the bond is redeemed by the issuer on the next call date. The YTW of a premium bond is equivalent to YTC because the bond issuer is likely to call it. A bond trading at a premium means the coupon rate is above the market yield.
Yield-to-worst is the lower of yield-to-call and yield-to-maturity. Figuring out which is is lower can be done quickly by understanding some tips. First, if a bond is callable then there will be a YTC. If not, YTM is the defacto lowest yield and will be used for spread-to-worst. However, if the bond is callable and it trades at a premium to par value, the YTC will be lower than YTM.
Callable bonds are most likely called when interest rates are low. The yield on callable bonds is typically higher because of the risk that investors will have to reinvest the proceeds at a lower interest rate, also known as reinvestment risk.
Example of Spread-to-Worst
Suppose a callable high-yield bond is issued with a 10-year maturity and a 5-year non-call protection provision (i.e. the issuer is not allowed to redeem the bond within five years). After three years interest rates are lower, which means there is potential for the issuer to call the bond in order to refinance at a lower coupon rate.
The bond that the investor owns is now trading at a premium. The YTC is compared to the yield of a 2-year Treasury—5 years of non-call protection minus the 3 years that have lapsed. The difference is the spread-to-worst, expressed in basis points.