What is the nominal return?
The nominal yield on a bond, represented as a percentage, is calculated by dividing all annual interest payments by the nominal or nominal value of the bond.
- The nominal yield on a bond, represented as a percentage, is calculated by dividing all annual interest payments by the nominal or nominal value of the bond.
- Two components combine to determine the nominal return on a debt instrument: the prevailing inflation rate and the issuer’s credit risk.
- The nominal yield does not always represent the annual yield because it is a percentage based on the nominal value of the bond and not on the actual price that was paid for that bond.
Understanding nominal performance
The nominal yield is the coupon rate of a bond. Essentially, it is the interest rate that the bond issuer promises to pay to bond buyers. This rate is fixed and applies to the life of the bond. It is also sometimes known as the nominal rate or coupon yield.
Nominal yield does not always represent annual yield because it is a percentage based on the nominal value of the bond and not the actual price that was paid to purchase that bond. Buyers who pay a premium greater than the face value of a given bond will receive a lower real rate of return (RoR) than the nominal return, while investors who pay a discount less than the face value will receive a higher real rate of Return. It’s also worth noting that bonds with high coupon rates tend to be called first, when called, because they represent the issuer’s largest liability relative to bonds with lower yields.
Take, for example, a bond with a face value of $ 1,000 that pays the bondholder $ 50 in interest payments annually. It would have a nominal return of 5% (50/1000).
- If the bondholder bought the bond for $ 1,000, the nominal return and the annual rate of return are the same, 5%.
- If the bondholder paid a premium and bought the bond at $ 1,050, the nominal return is still 5%, but the annual rate of return would be 4.76% (50/1050).
- If the bondholder obtained the bond at a discount and paid $ 950, the nominal return is still 5%, but the annual rate of return would be 5.26% (50/950).
The bonds are issued by governments for domestic spending purposes or by corporations to raise funds to finance research and development and for capital expenditures (CapEx). At the time of issuance, an investment banker acts as an intermediary between the bond issuer, which could be a corporation, and the bond buyer. Two components combine to determine the nominal return on a debt instrument: the prevailing inflation rate and the issuer’s credit risk.
- Inflation and nominal yield: The nominal rate is equal to the perceived inflation rate plus the real interest rate. When a bond is written, the current inflation rate is taken into consideration when establishing the coupon rate of a bond. Therefore, higher annual inflation rates push up the nominal yield. From 1979 to 1981, double-digit inflation loomed for three consecutive years. Consequently, three-month Treasury bills, which were considered risk-free investments due to the backing of the United States Treasury, peaked in the secondary market with a yield to maturity of 16.3% in December 1980 In contrast, the yield to maturity of the same three-month Treasury obligation was 1.5% in December 2019. As interest rates rise and fall, bond prices move inversely to rates, creating higher or lower nominal returns until maturity.
- Credit rating and nominal yield: Since US government securities essentially represent risk-free securities, corporate bonds tend to have higher nominal returns in comparison. Agencies like Moody’s assign credit ratings to corporations; its assigned value is based on the financial strength of the issuer. The difference in coupon rates between two bonds with identical maturities is known as the credit spread. Investment grade bonds have lower nominal yields at issue than non-investment grade or high yield bonds. Higher nominal returns carry a higher risk of default, a situation in which the corporate issuer is unable to make principal and interest payments on debt obligations. The investor accepts higher nominal returns knowing that the issuer’s financial health represents a greater risk to capital.