What is the nominal return?
The nominal yield of a bond, represented as a percentage, is calculated by dividing the total interest paid annually by the nominal, or bybond value.
Key points to remember
- The nominal yield of a bond, represented as a percentage, is calculated by dividing the total interest paid annually by the nominal value of the bond.
- Two elements combine to determine the nominal yield of a debt security: the prevailing rate of inflation and the credit risk of the issuer.
- The nominal yield does not always represent the current yield because it is a percentage based on the nominal value of the bond and not on the actual price paid for this bond.
Understanding Nominal Yield
The nominal yield is the coupon rate of a bond. Essentially, it is the interest rate that the bond transmitter promises to pay bond buyers. This rate is fixed and applies over the life of the bond. Sometimes it is also called nominal rate or coupon yield.
The nominal yield does not always represent the current yield because it is a percentage based on the nominal value of the bond and not on the actual price paid to buy this bond. Buyers who pay a premium above the face value of a given bond will receive a lower actual premium return rate (RoR) than the nominal return, while investors who pay a discount below nominal will receive a higher real rate of return. It should also be noted that links with coupon rate tend to be redeemed first, when callable, as they represent the issuer’s largest liability compared to lower-yielding bonds.
Take, for example, a bond with a face value of $1,000 that pays the bondholder $50 in interest payments per year. It would have a nominal return of 5% (50/1000).
- If the holder bought the bond for $1,000, the nominal yield and the current yield are the same, 5%.
- If the bondholder paid a premium and bought the bond at $1,050, the nominal yield is still 5%, but the current yield would be 4.76% (50/1050).
- If the bondholder got the bond at a discount and paid $950, the nominal yield is still 5%, but the current yield would be 5.26% (50/950).
What determines the nominal return?
Bonds are issued by governments for domestic spending purposes or by corporations to raise funds to finance research and development and to capital expenditure (CapEx). At the time of issuance, an investment banker acts as an intermediary between the bond issuer – which may be a company – and the bond buyer. Two elements combine to determine the nominal yield of a debt security: the prevailing rate of inflation and the credit risk of the issuer.
- Inflation and Nominal Return: The nominal rate is equal to the perceived rate of inflation plus the real interest rate. At the time a bond is purchased, the current rate of inflation is taken into consideration when establishing a bond’s coupon rate. Thus, higher annual inflation rates push the nominal return higher. From 1979 to 1981, double-digit inflation was observed for three consecutive years. Therefore, three months goods of treasurewhich were considered risk-free investments due to US Treasury support, peaked in the secondary market at a yield of 15.49% in December 1980. In contrast, the yield on the same three-month Treasury bond was 1.5% in December 2019. As interest rates rise and fall, bond prices move inversely to rates, creating higher or lower nominal yields.
- Credit Rating and Nominal Yield: US government securities representing essentially risk-free securities, corporate bonds generally hold higher nominal returns in comparison. Companies are affected credit scores by agencies such as Moody’s; their assigned value depends on the issuer’s financial strength. The difference in coupon rate between two bonds with identical maturities is known as the credit spread. Investment-grade bonds have lower nominal yields at issue than lower-grade or high-yield bonds. Higher nominal yields come with a greater risk of default, a situation in which the issuing company is unable to make principal and interest payments on the debt securities. The investor accepts higher nominal returns knowing that the financial health of the issuer poses a higher risk to the principal.