What is Nominal Yield?
A bond is a debt instrument which allows investors to lend money to a corporate or government entity for a defined period. In exchange the investors get a fixed return of interest called a coupon throughout the bond’s life. Upon maturity the bond issuer also redeems the principal to the investors.
‘Yield’ is the annualized rate of return of a bond. They can be of various types such as current yield, yield to maturity, nominal yield. This blog post is an in-depth analysis of nominal yield of bonds.
What is nominal yield?
Nominal yield is the starting point for calculating a bond’s return. Also known as the bond's coupon rate, is a fixed interest rate that a bond issuer agrees to pay to a bondholder until the bond is redeemed. A higher nominal yield indicates that a larger part of a bond’s face value will be received in interest every year. Nominal yield is stated in the name of the bond.
E.g., Company X Ltd. has a AAA credit rating. It issues 5% bonds of face value INR 100 with a life of two years. The nominal yield in this example is 5% or INR 5 (INR 100 * 5%). Nominal yield assumes that coupon payments are not reinvested by the bondholder. In other words, it works according to the simple interest rate and does not consider the compounding periods.
To calculate nominal yield, add all the coupon payments made during the year. If the bond makes quarterly interest payments, all four interest payments should be added. Divide the total of coupon payments by the bond’s face value. Multiply it by 100 to get the nominal yield as a percentage. This concept is discussed further later in the blog.
As stated earlier the nominal yield or coupon rate of a bond is fixed. This leads to an inverse relationship between bond prices and market interest rates. When interest rates rise, bond prices fall. Conversely, when market interest rates drop, bond prices shoot up. Where the market interest rate remains at par with nominal yield, the bonds also trade at par.
To understand the concept better, consider this. Market interest rates have risen to 6% as against 5% when the bonds were issued. However, Company X Ltd’s bonds continue paying 5% nominal yield. The 5% coupon rate appears less lucrative to investors when compared to the 6% market interest rate, leading to a fall in the demand of the bond, thereby, reducing its market price.
Suppose, an investor intends to sell his bond holding. The investor should be ready to sell his bond for less than its face value. There would be no buyers to take up a bond with face value 100 because buying a similar bond from the market can give the person a higher rate of interest. This bond is now said to be trading at a discount.
The table below summarizes the previously discussed points:
| Nominal Yield | Market Interest Rate | Bond Price | |
| Fixed | ↑ | ↓ | Discount Bond |
| Fixed | ↓ | ↑ | Premium Bond |
| Fixed | Same as nominal yield | No change, i.e. bond will trade at face value | Par Bond |
Nominal yield completely ignores the fluctuations in the market interest rate and in turn, fails to fathom the current market value of the bond. Thus, using nominal yield as an indicator of the actual return of a bond is grossly misguided and faulty. It should not be used in isolation and can at best be used as a reference rate.
How to Calculate Nominal Yield
|
Nominal Yield (%) = (Total coupon payments in a year÷Par value of the bond)*100 |
The Nominal Yield is calculated by dividing total coupon payments made in a year by the bond's par value, (not the actual price paid for that bond). On the contrary, the current Yield is calculated on the purchase price of the bond.
Continuing the example stated above, consider the three situations given below. Mr R bought 100 bonds at:
- par
- a premium of INR 10 each
- a discount of INR 10 each.
The current yield and nominal yield in the three situations would be:
| Bond Price (INR) | Annual coupon (INR) | Nominal Yield (%) | Current Yield (%) |
| 100 (par bond) | 5 | 5% | 5% |
| 110 (premium bond) | 5 | 5% | 4.54% |
| 90 (discount bond) | 5 | 5% | 5.55% |
Components Determining Nominal Yield
The two components that determine the nominal yield of a bond are:
-
Inflation: A higher inflation rate leads to a higher nominal yield. The nominal yield is the current inflation rate plus the real interest rate.
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The credit risk profile of the issuer: Credit rating agencies like CRISIL rate companies based on their financial strength. A company with a higher credit rating gives a lesser nominal yield. On the other hand, companies with a lower credit rating are relatively riskier. Hence, bond subscribers demand a higher coupon rate as compensation for undertaking higher risk.
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Frequently Asked Questions
Nominal yield spread is the difference between the yields of treasury and non-treasury bonds of the same maturity dates. Treasury bonds are government bonds, whereas non-treasury bonds are corporate bonds. As explained earlier, riskier bonds have a higher coupon rate. Keeping this in mind, consider this example. The government bond yield is 3%, and Company X Ltd's bond yield is 5%. The nominal yield spread would be (5-3) = 2%.
The nominal yield spread helps assess the yield expectation from government bonds and corporate bonds within a given timeline.
Effective interest rate is the real interest rate that reflects the percentage rate owed in interest on a bond. It is also referred to as effective annual interest rate, annual equivalent rate, or simply the effective rate.
| Effective interest rate = (1+i/n {)} ^ {n} -1 |
where,
i = nominal interest rate
n = number of compounding periods.
Effective interest rate factors in the effects of compounding and other bond charges which are not considered by the nominal interest rate. This is the main difference between the two and why an effective interest rate gives a more accurate picture than a nominal yield.
For example, Company K issues bonds with semi-annual coupon payments of 10%. Face value is INR 1000, and the bonds are redeemable after 2 years. (There are 4 compounding periods of 6 months each)
Nominal interest rate = (10/1000)*100 = 1%
Effective interest rate =(1+10/4 {)} ^ {4} -1= 1.4414%
Usually, organizations like banks publish the nominal interest rate when they are charging interest as it is lower and does not reflect how much interest the consumer owes on the balance after a year of compounding. On the other hand, when paying interest, organizations advertise the effective interest rate because it is higher than nominal interest rate.
Nominal YTM = Coupon rate * Face value * No. of years until maturity Continuing the same example as above,
Nominal YTM for the first year = 5% * 100 * 2 = INR 10 or 10%
Nominal YTM for the second year = 5% * 100 * 1 = INR 5 or 5%
| Nominal Yield (%) = (Total coupon payments in a year÷Par value of the bond)*100 |
| Effective Interest Rate (EIR) = (1+i/n {)} ^ {n} -1 |
From the above two equations, nominal yield can also be stated as,
| Nominal Yield = n(∛EIR -1) |
E.g.: If the EIR is 12% compounded annually, the nominal rate would be 5.83%.