Spread-To-Worst: What is it?
Spread-to-worst (STW) is a metric used to compare returns from several markets or between the best and worst performing securities in a particular market, which is often the bond market.
Knowledge of Spread-To-Worst (STW)
In the bond market, the yield-to-worst (YTW) of a bond and the yield-to-worst of a U.S. Treasury instrument with a comparable tenure are different from one another. The STW is stated in “basis points (bps)” and is either yield-to-call (YTC) or yield-to-maturity (YTM), depending on which is lowest.
The lowest yield that might be paid on a bond without the issuer actually failing is known as the YTW, and STW employs it. Investors incur the risk of receiving lesser returns from a bond if it is callable. This is due to the fact that a bond investor would have to reinvest in fixed income assets with lower yields in an environment where interest rates are decreasing. Call clauses are often included in municipal and corporate bonds.
The YTW of a bond is determined for all potential call dates prior to maturity. If the bond contains a call option and the issuer has the choice to reissue it at a lower coupon rate, it is anticipated that a prepayment will take place. The YTC or YRM that is lower is the YTW. In the event that the bond is redeemed by the issuer on the subsequent call date, YTC is the annual rate of return. Because the bond issuer is likely to call it, the YTW of a premium bond is equal to the YTC. A bond’s coupon rate is higher than the market yield if it trades at a premium.
Applying STW to various markets might help investors make choices that could maximize the value of their portfolios. For instance, if STW between U.S. treasuries and stocks was high, let’s say above 40%, then the investor may think about shifting their portfolio’s composition towards stocks. STW will be largely influenced by factors like short- or long-term interest rates, investor confidence, and other comparable metrics, as is the case with the majority of market reactionary indicators.
Knowing a few tips can help you determine which is lowest fast. First, a YTC will exist if a bond is callable. If not, YTM will be utilized for STW as it is the de facto lowest yield. The YTC will, however, be less than YTM if the bond is callable and trades at a premium to par value.
When interest rates are low, callable bonds are most likely to be called. The danger that investors will have to reinvest the funds at a lower interest rate, commonly known as reinvestment risk, causes callable bonds to normally have higher yields.
Spread-to-Worst Examples (STW)
Consider a callable high-yield bond that has a five-year non-call protection clause and a 10-year maturity (i.e., the issuer is not allowed to redeem the bond within five years). When interest rates are lower after three years, the issuer may choose to call the bond and refinance at a reduced coupon rate.
The investor’s bond is now selling at a premium. The five years of non-call protection less the three years that have passed since the YTC was issued are subtracted to get the yield of a two-year Treasury. The basis-point STW represents the difference.