What is a Nominal Yield
A nominal yield is the coupon rate on a bond. The nominal yield is the interest rate (to par value) that the bond issuer promises to pay bond purchasers. This rate is fixed, applies to the life of the bond, and is sometimes referred to as nominal rate, coupon yield or coupon rate.
BREAKING DOWN Nominal Yield
The nominal rate does not always represent the overall return. Buyers who pay a premium that's more than the coupon price for a given bond will receive a lower actual rate of return than the nominal rate, while investors who pay a discount that's less than the coupon price will receive a higher actual rate of return. It's also worth noting that bonds with high coupon rates tend to get called first, when callable, as they represent the issuer's greatest liability relative to bonds with lower yields.
The Components of Nominal Yield
Bonds are issued by governments for domestic spending purposes or by corporations to raise funds for financing research and development and capital expenditure (CAPEX). At the time of issuance, an investment banker acts as an intermediary between the bond issuer, which might be a corporation, and the bond buyer. Two components combine to determine the nominal yield on a debt instrument: the prevailing rate of inflation and the credit risk of the issuer.
Inflation and Nominal Yield
The nominal rate equals the perceived rate of inflation plus the real interest rate. At the time a bond is underwritten, the current rate of inflation is taken into consideration when establishing the coupon rate of a bond. Thus, higher annual rates of inflation push nominal yield upward. In 1979 through 1981, double-digit inflation loomed for three consecutive years. Consequently, three-month Treasury bills that were considered risk-free investments because of the backing of the U.S. Treasury peaked in the secondary market at a yield to maturity of 16.3% in December 1980. By contrast, the yield to maturity on the same three-month Treasury obligation currently sits at 0.27% in June 2016, the product of near-zero inflation and a corresponding ultra-low Fed funds target rate. As interest rates rise and fall, bond prices move inversely to rates, creating higher or lower nominal yields to maturity.
Credit Rating and Nominal Yield
With U.S. government securities essentially representing riskless securities, corporate bonds typically hold higher nominal yields by comparison. Corporations are assigned credit ratings by agencies such as Moody’s who assign values 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 hold lower nominal yields at issuance than non-investment grade or high-yield bonds. Higher nominal yields come with a greater risk of default, a situation in which the corporate issuer is not able to make principal and interest payments on debt obligations. The investor accepts higher nominal yields with the knowledge that the issuer’s financial health poses a greater risk to principal.