What Is Nominal Yield?
Let me explain nominal yield to you directly: it's the interest rate on a bond, shown as a percentage, that you get by dividing the total annual interest by the bond's face or par value.
Key Takeaways
You should know that nominal yield comes from dividing annual interest by the bond's par value, and it's influenced by inflation and the issuer's credit risk. Remember, it doesn't always match the current yield since it's based on par value, not what you actually paid for the bond.
Understanding Nominal Yield
I want you to understand that nominal yield is simply the coupon rate on a bond—it's the interest the issuer promises to pay you as the buyer. This rate stays fixed throughout the bond's life, and you might hear it called nominal rate or coupon yield.
But here's the key point: nominal yield isn't always your current yield because it's calculated using the par value, not the price you paid. If you buy at a premium above face value, your actual return drops below the nominal yield; if you get it at a discount below face value, your return goes higher. Also, bonds with high coupon rates are often called first if callable, as they cost the issuer more compared to lower-yield ones.
Consider this example: a bond with a $1,000 face value paying $50 annually in interest has a 5% nominal yield (50 divided by 1000). If you buy it for $1,000, both nominal and current yields are 5%. Pay $1,050 as a premium, and nominal stays 5%, but current yield is 4.76% (50 divided by 1050). Get it for $950 as a discount, nominal is still 5%, but current yield rises to 5.26% (50 divided by 950).
What Determines the Nominal Yield?
Governments issue bonds for spending, and corporations do it for R&D or capital expenses. An investment banker connects the issuer and buyer at issuance. Two main factors set the nominal yield: inflation and the issuer's credit risk.
Inflation and Nominal Yield
Nominal rate equals expected inflation plus the real interest rate. When underwriting a bond, they factor in current inflation to set the coupon rate, so higher inflation means higher nominal yields. From 1979 to 1981, double-digit inflation pushed three-month Treasury bills to a peak of 15.49% in December 1980. By December 2019, that yield was just 1.5%. As rates change, bond prices move opposite, affecting nominal yields.
Credit Rating and Nominal Yield
U.S. government bonds are basically risk-free, so corporate bonds have higher nominal yields. Agencies like Moody’s rate corporations based on financial health. The credit spread is the difference in rates for bonds with the same maturity. Investment-grade bonds start with lower nominal yields than high-yield or junk bonds. Those higher yields come with default risk, where the issuer might not pay principal or interest. You accept that higher yield knowing the issuer's finances pose more risk to your investment.
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