Nominal Yield

What Is Nominal Yield?

The nominal yield is a bond’s rate of return. Investors use it to determine the interest rate earned from a bond investment. The interest rate is fixed and applicable to the entire duration of the bond. Nominal yield is also referred to as a coupon yield.

The coupon yield is a steady income for the investor. The investor receives interest till its maturity date or till they sell it. Bonds are sold in the secondary market. The interest payment is directly proportional to the coupon yield; the higher the yield, the higher the interest rate payment. But higher yields come with higher risks.

• The nominal yield represents the bond's interest rate. The investor receives interest payments periodically—till their maturity date. Nominal yield is also referred to as a coupon yield.
• One can divide the annual interest payment by the bond's face value to calculate the coupon yield. The resulting ratio represents the coupon yield. Usually, coupon yields are expressed in percentages.
• To compare bonds, investors use the coupon yield. Experienced investors track the growth of a bond investment by comparing the coupon yield curve with inflation.

Nominal Yield Explained

The nominal yield is a bond’s rate of return. Investors use it to determine the interest rate earned from a bond investment. The interest rate is fixed and applicable to the entire duration of the bond. Nominal yield is also referred to as nominal rate, coupon rate, or coupon yield. The coupon rate can be high or low; the interest payment is directly proportional to the coupon yield.

Coupon yield is associated with debt securities, most frequently a bond. Companies issue bonds to attract investors. In return, the bond issuer offers the investors a steady income stream. The repayment is in the form of periodic interest payments; upon maturity, the investors recover the principal amount. Companies issue bonds to raise capital. Further, they use the raised capital for projects and business expansion.

Bond agreements state bond issuers can use the investor's money for a certain time. Most bond issuers pay interest every quarter or once a year. For calculating the coupon yield, we divide annual interest rate payments by the bond’s par value. Coupon rates are fixed and do not vary during the bond duration.

Investors prefer bonds that offer a higher coupon yield. Usually, when the interest rate goes up, bond market prices decline. Also, investors prefer bonds with shorter maturity periods. Bonds are considered relatively risk-free, but that is not always the case. The following risks are associated with bonds:

• Interest rate risk - changing market conditions can harm the investment.
• Credit risk - a bond issuer may default on interest payments.
• Call risk - the issuer can terminate the bond before its maturity date (if it is a callable bond).
• Inflation risk - inflation impacts the purchasing power of bond returns.

Therefore, investors must research the market and particular security before investing. If not, an investor might invest in a high-risk bond without knowing the risks. For example, junk bonds are known for their high yield but often come with increased default risks.

Now, to compare bonds, investors use the coupon yield. Experienced investors track the growth of a bond investment by comparing the coupon yield curve with inflation. Fundamentally, government bonds are considered the safest. It is highly unlikely for a stable government to default on its payments.

Buyers who pay a premium above the coupon price will get a lower actual rate of return than the nominal rate of return. In contrast, investors who purchase the bond at a discount (lower than the coupon price) receive a higher actual rate of return.

The nominal rate includes the expected inflation rate plus the real interest rate. Bond issuers consider the inflation rate at the time of underwriting to determine the coupon rate. Thus, the higher the inflation, the higher the coupon yield.

Formula

The nominal yield formula is as follows:

Nominal Yield = Annual Interest Payment/Bond's Face Value

Here, the frequency of interest payments is divided by the face value of the bond.

Example

Let us look at a nominal yield example.

Sharon bought a bond with a face value of $900. The bond pays Sharon an interest of $90 annually (till maturity).

Based on this value, the coupon yield can be calculated as follows:

• Nominal Yield = $90/$900 = 10%

Now let us assume that the bond’s nominal and current yields are the same. In such a scenario, Sharon pays a premium of $990, but the coupon yield will remain the same at 10%. On the other hand, the current yield falls to 9%:

• Current Yield = 90/990 = 9%

Let us consider another scenario; Sharon buys the bond at a discount—for $810. Here, the coupon yield would be the same (10%). But the current yield will rise to 11.11%:

• Current Yield = 90/810 = 11.11%

Nominal Yield vs Current Yield

Now, let us look at the normal yield vs current yield comparison to distinguish between the two.

• Nominal yield or coupon yield is the ratio of interest earned and the bond's face value. On the other hand, the current yield is the ratio of earned interest and the bond's current price.
• Coupon yield depicts the interest rate earned by an investor (from a bond). In comparison, the current yield reflects a bond's expected rate of return.
• The coupon yield needs to be comprehensive to depict the bond's ultimate return. In comparison, the current yield must verify the price movement effect—between the bond's purchase date and the valuation date.

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to what is Nominal Yield. Here, we explain it with its formula, example, and comparison with current and coupon yields. You can learn more about it from the following articles –

• Effective Yield
• Bond Yield Formula
• Negative Yield Bond