When deciding whether to include a specific bond in your portfolio, as an investor, it can be beneficial to consider certain factors. For instance, bond prices may decrease if interest rates rise. Then how to decide whether a bond is worth adding to your portfolio? Nominal yield is one important tool that helps assess the bond and make your decision. Let us understand how nominal yield works in this article.
Before knowing the definition of nominal yield, let us understand a few basic terms.
a. Bond:
A debt instrument that enables investors to extend a fixed-term loan to a company or a governmental body.
b. Yield:
Yield is defined as a bond’s annualized rate of return.
c. Coupon Rate:
The coupon rate is defined as the amount that has to be paid to the bondholder by the issuer until its maturity date, and it has a fixed bond tenure throughout the year. Sometimes, coupon rate and nominal yield are used interchangeably.
d. Coupon Rate v/s Yield:
The annual rate of interest that a bond pays, whereas yield is the rate of return it generates.
What is Nominal Yield?
The set interest rate that a bond issuer promises to pay to a bondholder until the bond is redeemed is called the nominal yield or bond’s coupon rate. The interest paid on a bond each year will increase if the nominal yield is higher.
How is nominal yield calculated? Nominal yield is calculated by dividing the total annual interest payments by the bond’s face value or par value. It is usually expressed in percentages.
Nominal Yield = Annual Interest Payment / Par Value
Let us consider an example for simple understanding.
A bond has a ₹2,000 par value, an 8% coupon, and is due 2034. In trade, the bond might be worth ₹1600 a year from now, ₹2,400 six months from now, and so on. However, the nominal yield remains the same and will remain so, i.e., 8%.
The nominal yield of a bond is fixed. As a result, the price of bonds and market interest rates are inversely related. This means bond prices decrease when interest rates increase. Whereas bond prices increase when market interest rates decline. The bonds trade at par, where the market interest rate still equals the nominal yield.
What factors impact nominal yield?
The following factors determine the nominal yield on the debt instrument.
a. Inflation
The nominal rate equals the real interest and perceived inflation rates. The current inflation rate is considered when determining a bond’s coupon rate at the time the bond is underwritten. As a result, greater yearly inflation rates drive increased nominal yield.
b. Market interest rates
A bond’s nominal yield or coupon rate is fixed. As a result, the price of bonds and market interest rates are inversely related. Bond prices decrease when interest rates increase and vice versa.
c. The credit risk profile of the issuer
Credit ratings agencies such as CRISIL and Moody rate the companies based on financial strength. A company that has a better credit rating offers a lower nominal yield. Conversely, companies with a lower credit rating are riskier. So, in exchange for taking on greater risk, bond subscribers seek a higher coupon rate.
What can investors understand from nominal yield?
What kind of interest rate an investor can anticipate receiving from a bond investment can be determined by nominal yield. The interest you may earn on the bond would increase with the nominal yield. You should know that higher nominal yields can also be a sign of increased risk. Even though they are typically thought of as safer investments than stocks, they do carry some risk. Bond investors’ risks include credit, inflation, call, and others.
Limitations of nominal yield
Nominal yield ignores changes in market interest rates, which makes it difficult to comprehend the bond’s present market worth. Consequently, using nominal yield as a gauge of a bond’s actual return is utterly flawed and wrong. It should not be used independently but only as a benchmark rate.
Nominal yield vs. current yield
| Nominal Yield | Current Yield |
| The nominal yield refers to the interest rate earned by an investor (from a bond) | The current yield depicts a bond’s expected rate of return |
| Nominal Yield = Annual Interest Payment / Par Value | Current Yield = Annual Interest Payment / Current Market Price of Bond |
| With the changes in interest rates and bond prices on the market, we can see that the nominal yield does not accurately reflect the return anticipated on a bond | Instead of using the bond’s face value, the current yield compares the annual interest payments with the bond’s current market price to account for market volatility |
Conclusion
When deciding whether to include a specific bond in your portfolio as an investor, it can be beneficial to consider nominal yield. However, it is not arbitrary. Bondholders should consider other aspects like the bond issuer’s creditworthiness, inflation, and other factors. On the other hand, bond issuers should consider variables like inflation rates, market risk, and the state of interest rates when determining how to establish the nominal rate.
Disclaimer
- This blog is exclusively for educational purposes
- Investments in the securities market are subject to market risks; read all the related documents carefully before investing
