Nominal yield is a fixed percentage amount calculated for fixed income securities representing a stated yield for a bond. It is calculated by dividing the annual interest payments by the face value of the bond. It is also referred to as the coupon rate of a fixed income security.
How to Calculate Nominal Yield
The calculation of a nominal yield in annual terms is done by adding all the bond payments made during the year. If there is one annual payment, then that is it. If it is a semi-annual or quarterly paying bond, you must add all of the payments for the year. Then, divide the total amount of annual interest payments by the face or par value of the bond.
Consider a bond with a face value of $1,000 that makes $25 semi-annual payments. What is the nominal yield?
1. First, the semi-annual payments should be added to calculate the total amount of bond payments made during the year:
$25 x 2 = $50
2. Next, divide that total by the face value of the bond:
$50 / $1,000 = 0.05
Stated in percentage terms, the bond shows a nominal annual yield of 5%.
Nominal Yield Explained
The nominal yield is simply the coupon rate of a bond. It is the interest rate that a bond issuer will promise to pay to the bondholders. The rate is usually fixed over the life of the bond.
Although the nominal yield is an annual percentage, it does not necessarily represent the realized annual return of a bond. It is because of the market fluctuations in interest rates and their impact on bond prices.
The relationship between interest rates and bond prices is inverse. When interest rates rise, bond prices drop. It is because the stated coupon rates are fixed, as mentioned earlier.
When market interest rates rise, the fixed coupon rate is relatively lower than other bonds, and it makes the bonds unattractive and cheaper. It is known as a bond trading at a discount.
On the contrary, when market interest rates drop, the fixed coupon rate is relatively higher than other bonds, which makes the bond more attractive and more expensive. It is known as a bond trading at a premium.
In a case where the interest rate is equal to the fixed coupon rate, the bond will trade at exactly its face value. It is known as trading at par.
Building off our earlier example where we take out a bond with a nominal annual yield of 5%.
Does it represent the yield an investor should expect for buying the bond?
It depends on what price the bond was purchased at.
If the market interest rate is lower than 5%, then the bond will be more expensive (premium).
If the market interest rate is higher than 5%, then the bond will be cheaper (discount).
Consider that the market interest rate is lower than 5%, and the bond was purchased for $1,100. Although the nominal yield is still 5%, the actual rate of return would be 4.545% ($50 / $1,100).
Now consider that the market interest rate is higher than 5%, and the bond was purchased for $900. Although the nominal yield is still 5%, the actual rate of return would be 5.556% ($50 / $900).
Nominal Yield vs. Current Yield
We see that the nominal yield does not give an accurate representation of a return expected on a bond due to market fluctuations of interest rates and bond prices. However, the current yield is able to capture market fluctuations by comparing the annual interest payments with the current market price of the bond instead of the face value.
Drivers of Nominal Yield
Nominal yield is impacted by two factors:
The nominal rate is driven by inflation. It is because the nominal rate will equal the inflation rate plus the real interest rate. When a bond is issued, the inflation rate is taken into account when determining the coupon rate.
If inflation is high, the coupon rate needs to also be higher in order to compensate investors for the loss of purchasing power that arises from inflation.
2. Credit Risk of Issuer
The nominal rate is also driven by the credit risk of the issuer. If the credit risk of an issuer is high, then there is a higher probability that a bond investor will not receive contractual cash flows. To compensate for the additional risk, the coupon rate needs to be higher to incentivize investors to take on that risk.
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