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Investors Need to Know This Number In Volatile Markets

·7 min read
nominal yield
nominal yield

Bonds can add diversification to a portfolio if you’re looking for fixed-income investments. If you’re new to bond investing, you may not be familiar with certain key terms, such as nominal yield. A bond’s nominal yield represents its coupon rate or the amount of interest you can expect to earn. Knowing how to calculate nominal yield is important when evaluating bond investments. If you want help with figuring out the nominal yield of your investments, consider working with a financial advisor.

What Is Nominal Bond Yield?

A bond is a debt instrument that can provide a steady fixed income for investors. When you purchase a bond, you’re agreeing to let the bond issuer use your money for a set time period. The bond issuer can make interest payments back to you, typically on a quarterly or yearly basis.

Once the bond matures, the issuer returns your initial investment to you along with any remaining interest due. That’s a brief overview of how bonds work and it’s important for understanding nominal yield.

The nominal yield of a bond is its coupon rate. The coupon rate of a bond is the interest rate the issuer guarantees to investors for the duration of the bond term. Coupon rates are fixed and don’t change over the life of the bond. Nominal yield is also referred to as nominal bond yield, coupon yield or nominal rate.

What Does Nominal Yield Tell Investors?

nominal yield
nominal yield

Nominal yield can tell you what kind of interest rate you can expect to earn from a bond investment. The higher the nominal yield, the more interest you could earn on the bond. However, higher nominal yields can also indicate a greater degree of risk. While bonds are generally viewed as being safer investments than stocks, they’re not risk-free. Bond investors can face a variety of risks, including:

  • Credit risk. Also referred to as default risk, it means how likely the bond issuer is to meet their obligations to investors.

  • Inflation risk. When rising prices signal higher inflation, that can shrink the purchasing power of bond returns.

  • Interest rate risk. A changing interest rate environment can affect investment outcomes, as interest rates and bond prices have an inverse relationship.

  • Call risk. When a bond is callable, the issuer can terminate the bond ahead of its maturity date, which can reduce the interest earnings for investors.

High yield bonds, also called junk bonds, can offer higher nominal yields to investors. At the same time, they can also carry much greater default risk.

That’s because these bonds are associated with issuers that have lower credit ratings. In other words, the chances of an investor losing money because the bond issuer is unable to meet its obligations is higher. So in order to attract investors and raise capital, those bond issuers will offer a higher nominal yield.

The nominal yield or coupon rate can be a good starting point for evaluating bond investments. But there are other factors to consider in order to get a clearer picture of whether a bond is a good fit for your portfolio.

How Is Nominal Yield Calculated?

The nominal rate or yield measures the percentage of the bond’s face value that’s paid out to investors in interest on a yearly basis. To calculate the nominal yield of a bond, you’ll need to know two things:

  • Bond’s face value

  • Frequency of interest payments

The first step in calculating nominal yield is adding up all of the bond’s interest payments over the course of a year. Again, bonds can make interest payments periodically or annually. So you might have multiple payments or just one.

Once you’ve added up all of the bond’s interest payments, you’d divide that amount by the bond’s face value. You can then take that number and multiply it by 100 to find the nominal yield expressed as a percentage.

It’s important to remember that there can be a difference in a bond’s face value or what it’s worth and the amount you pay for it. Some bonds sell at a discount, meaning you pay less to buy it than the face value. Some bonds sell at a premium, so you pay more than face value. Whether you purchase bonds at a premium or discount can affect the amount of interest realized on the investment.

Difference Between Current Yield and Nominal Yield

The current yield of a bond is the interest earned annually divided by the bond’s current price. Unlike nominal yield, current yield doesn’t take the bond’s face value into account. While nominal yield tells you the interest rate a bond will earn, the current yield tells you the expected rate of return.

They sound similar but they measure a bond’s potential as an investment in different ways. Together, current yield and nominal yield can help you decide if a bond is worth your time and money. You can also use current and nominal yields to compare bonds to other income-producing investments, such as dividend stocks or real estate investment trusts (REITs).

How a Bond’s Nominal Yield Is Set and Why It Matters?

nominal yield
nominal yield

The nominal yield or coupon rate of a bond is not arbitrary. There are several factors bond issuers can consider when deciding how to set the nominal rate, including:

  • Inflationary risks and which way consumer prices are trending

  • Credit or default risk of the bond issuer

  • Interest rate environment

As an investor, it can be helpful to consider those same factors when determining whether to add a particular bond to your portfolio. If interest rates are going up, for example, bond prices can fall. In that scenario, bonds that have shorter maturities tend to fare better than those with longer maturities. As bond prices fall, yields increase and vice versa. Longer-term bonds can lose value while rates are on the incline.

It’s also important to consider the credit and default risk profile a bond. You may be tempted to invest in junk bonds that hold the promise of a much higher yield but your odds of losing money are greater. If you tend to be more conservative in nature with your investments, you may be better off choosing a bond with a more modest nominal rate that also carries less risk.

The Bottom Line

Bonds can play an important role in bringing balance to a portfolio. If stocks are flagging in a volatile market, for example, bonds can provide steady income. Understanding nominal yield or coupon rate is a small, but important, part of the bond investing puzzle.

Investing Tips

  • Consider talking to a financial advisor about how to calculate the nominal yield of a bond and where bonds belong in your investment strategy. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • If you’d like to invest in individual bonds you can purchase them through an online brokerage account. Online brokerages allow you to trade bonds, stocks and other securities conveniently from your laptop or mobile device. When comparing online brokerages, consider the range of investments offered, including bonds. Also, consider the fees you might pay to trade different types of securities as well as the minimum investment required to get started.

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The post Nominal Yield: What It Is and How to Calculate It appeared first on SmartAsset Blog.