There is a lot more to investing in bonds than simply looking at the stated, or coupon, interest rate. Many bonds are callable, which means that the issuing company has a right to buy the bonds back early at a predetermined date or dates. If this happens, your effective yield of holding the bond could potentially be lower than you expect, so it's important to analyze the worst-case, known as the bond's yield to worst. Here's how to calculate this for your bonds.
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Calculating yield to worstBefore you start, you'll need to have some information handy, including:
- The price you paid, or the market price, of the bond.
- The bond's par value.
- All potential call dates.
- The bond's maturity date.
- The yearly interest payment, or the coupon rate.
Now, figure out the bond's current annual interest rate based on the price you paid. You can do this by dividing the annual interest payment by the price you paid, or current market value of the bond. Then, multiply by 100 to convert to a percentage.
This is the bond's yield each year based solely on interest payments. So, to find the yield over the remaining life of the bond, multiply this rate by the number of years remaining. Do the same for each call date.
Next, you need to determine the yield that comes from the bond's market price by subtracting the price you paid from the bond's face (par) value. Divide this by the bond's face value and multiply by 100. Keep in mind that this yield can be negative if you paid more than face value for the bond.
Finally, add the two types of yield -- interest rate and bond price -- for each of the possible call dates as well as the maturity dates. Divide by the number of years to convert to an annual rate. The lowest rate is the yield to worst for your bond.
An exampleLet's say you buy a bond with a par value of $1,000 and a coupon rate of 5%, and that you paid $1,030 for it. And we'll say that the bond matures in five years, with possible call dates in two years and four years.
Based on this information, we can see that the bond pays $50 per year. So we can calculate its current interest rate like this:
If the bond is held to maturity, five years of interest would produce a 24.25% total yield. Or, if the bond was called after two or four years, you would have a total yield of 9.7% or 19.4%.
Next, since you bought the bond for a premium, we need to account for this contribution to the total yield.
Finally, we can calculate the yield to worst using a table like this and comparing the annual yields of each call date:
Note: This calculation assumes the bond's annual dividends are not reinvested each year. If this is the case, a new annual interest payment would need to be calculated for each year, and the then-current market price of the newly acquired bonds would need to be taken into account.
So, in this case, the first possible call date would produce the worst possible yield. As a bond investor, this is an important number to use when contemplating an investment, as it tells you the lowest possible yield (other than a default) you can expect.
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