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Bonds are a kind of financial product that you can use to get a regular, fixed income. You are giving the bond issuer permission to use your funds for a particular period when you purchase a bond. Your bond issuer may repay you with interest payments at specific intervals, usually every quarter or year.
At bond maturity, you will get your original investment back plus any accrued interest from the issuer. What type of interest rate you might expect from investing in bonds can be determined by the nominal yield.
So, what exactly is a nominal yield? Let’s take a closer look at it.
What is a nominal yield?
Nominal yield is a predetermined percentage used to represent the stated yield on bonds in fixed-income securities. This rate is also known as the coupon rate.
Despite being expressed as an annual percentage, the nominal yield does not always correspond to the bond’s realised annual return. The reason for this is the varying interest rates in the market and how they affect the price of bonds.
Bond prices and interest rates are inversely correlated. If the former one falls, the latter one climbs.
Expected inflation plus the real interest rate make up the nominal rate. When setting the coupon rate, bond issuers consider the rate of inflation throughout the underwriting process. Hence, the coupon yield increases with inflation.
Nominal yield calculation
The nominal rate, often known as the yield, is a percentage of the bond’s face value distributed to investors each year in interest. Two things are needed to figure out a bond’s nominal yield. Those are the face value of the bond and the regularity of the interest payments.
- The bond’s total interest payments for one year are added to determine the nominal yield.
- Bonds provide the option to pay interest either periodically or annually. Therefore, you may have a single payment or several.
- The total interest payments on the bond would then be divided by the bond’s face value.
- After that, multiply that figure by 100 to get it as a percentage.
The nominal yield formula is the total annual interest payments/Bond’s face value.
Here’s a visual illustration of the nominal yield formula:
For example, if ABC Ltd. has a credit rating of AAA and issues a bond with a face value of ₹1,000 and pays ₹60 yearly, the nominal yield would be 6% per year.
It’s crucial to remember that the price you pay for a bond may differ from its face value.
Understanding nominal yield spread
Diverse financial instruments with different maturities, credit ratings, issuance companies, or risk levels have different yields, called a yield spread. For example, the nominal yield spread shows the discrepancy between two different nominal interest rates, like the 10-year Treasury bond and the 5-year Treasury bond.
Factors influencing nominal yield
- Inflation
When prices rise, the nominal rate follows accordingly. The reason is that the nominal rate will be the sum of the actual interest rate and inflation. When bond prices are fixed, the coupon rate is calculated by factoring in the inflation rate.
Inflation makes prices go up, so the coupon rate needs to increase to make up for investors’ lost buying power.
- Issuer credit risk
Another factor that determines the nominal rate is the issuer’s credit risk. Bondholders who have doubts about the issuer’s trustworthiness risk missing out on assured payments.
Real yield vs nominal yield
| Aspect | Real yield | Nominal yield |
| Meaning | The yield on an investment after inflation adjustments. | The stated yield on an investment before inflation. |
| Purpose | Real yield reflects the true growth in buying power. | The nominal yield indicates the current return without inflation adjustment. |
| Use | Real yield is used to evaluate the actual growth of an investment. | Nominal yield is used for the initial assessment of an investment’s return. |
| Impact of Inflation | Real yield accounts for inflation, showing the real earnings on investment. | Nominal yield does not consider inflation and may overstate actual earnings. |
Conclusion
The nominal yield quoted on a bond is just the starting point for evaluating its potential returns. Inflation, credit risk, and interest rate fluctuations all influence whether the realised gains match the coupon rate. Calculating the real yield after removing inflation gives a better evaluation of an investment’s growth in purchasing power.
For fixed-income investors, appreciating the gap between nominal and real yields is crucial for making informed decisions.
FAQs
The nominal rate, also known as the coupon rate, is the interest rate stated on a bond’s face value and remains fixed throughout the bond’s life. It represents the percentage of the face value that the bondholder will receive annually. In contrast, the current yield is calculated by dividing the bond’s annual interest payments by its current market price, reflecting the return an investor would expect based on the bond’s price today.
Nominal yield refers to the fixed interest rate paid on a bond’s face value, which is the bond’s annual coupon payments. Annual yield can be a broader term that may encompass various yield calculations on an annual basis, including nominal yield. However, it’s often used interchangeably with nominal yield in the context of bonds, where both terms describe the annual interest received based on the bond’s par value.
Nominal yield is the interest rate paid on the face value of a bond, which does not change over the bond’s tenure. Running yield, also known as current yield, is the annual income from the bond divided by its current market price. Running yield changes with the bond’s market price and provides a snapshot of the bond’s yield at the current market value.
In finance, yields can be categorised in various ways, but three common types are:
Nominal yield: The stated interest rate on a bond’s face value.
Current yield: The annual income (interest or dividends) divided by the current price of the security.
Yield to maturity (YTM): The total return anticipated on a bond if held until it matures, accounting for interest payments and capital gains or losses.
In India, the yield curve is calculated using the interest rates of government securities across different maturities. The Reserve Bank of India (RBI) publishes these rates, which are then plotted on a graph to form the curve. The yield curve reflects the market’s expectations of future interest rates and economic activity. To calculate it, one would typically gather the yields of bonds with varying maturities and plot them to show the relationship between yield and time to maturity.