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CandleFocus Glossary Editor
Nominal yield, also referred to as coupon rate, is the yield percentage of a bond based on its face value, or par value. Generally, it is calculated by dividing the payment of annual interest by the par value of the bond. It is important to note that the nominal yield of a bond doesn’t account for fluctuations of the bond’s market price, so the nominal yield of a bond isn’t indicative of the current yield, or yield to maturity.
Bonds issued by corporations with high quality credit ratings, such as AAA, generally have lower nominal yields to reflect the lower amount of risk associated with them as these entities are more likely to repay their debts. Conversely, nominal yields of higher risk bonds, such as those issued by firms with a lower credit, is higher to compensate for the higher risk associated with the investment.
The nominal yield, however, does not directly take inflation into account. Inflation forces up the general cost of living, so it is important to consider the effects of inflation when evaluating investments, as a flat nominal return may not be worth the same amount after inflation has been taken into account.
As inflation increases, the variability of a nominal yield’s value increases. A secure bond with a 6% nominal yield may generate a positive return if inflation is 5%. However, if inflation increases to 10%, then the nominal 6% yield of that bond would produce a real return of negative 4%. Therefore, it is important to understand the real rate of return of an investment in the context of inflation, the purchase price of the bond, and the tax implications of the investment.
In conclusion, nominal yield is a measure of the return on a security based on its face value, ignoring the effects of inflation, the actual market price, and any tax implications. It is not an indicator of the current return of the security and does not account for the potential volatility of the investment due to that the effects of inflation. For these reasons, it is important to consider both the nominal yield and the real return of a given investment.
Bonds issued by corporations with high quality credit ratings, such as AAA, generally have lower nominal yields to reflect the lower amount of risk associated with them as these entities are more likely to repay their debts. Conversely, nominal yields of higher risk bonds, such as those issued by firms with a lower credit, is higher to compensate for the higher risk associated with the investment.
The nominal yield, however, does not directly take inflation into account. Inflation forces up the general cost of living, so it is important to consider the effects of inflation when evaluating investments, as a flat nominal return may not be worth the same amount after inflation has been taken into account.
As inflation increases, the variability of a nominal yield’s value increases. A secure bond with a 6% nominal yield may generate a positive return if inflation is 5%. However, if inflation increases to 10%, then the nominal 6% yield of that bond would produce a real return of negative 4%. Therefore, it is important to understand the real rate of return of an investment in the context of inflation, the purchase price of the bond, and the tax implications of the investment.
In conclusion, nominal yield is a measure of the return on a security based on its face value, ignoring the effects of inflation, the actual market price, and any tax implications. It is not an indicator of the current return of the security and does not account for the potential volatility of the investment due to that the effects of inflation. For these reasons, it is important to consider both the nominal yield and the real return of a given investment.