Definition and Understanding: The coupon rate on a bond is also known as the nominal yield. The interest payments investors get from their bond investments come from the this yield.
When new issues come out, the coupon rate represents the interest paid and does not fluctuate. There is no formula or calculation for the nominal yield - it is set by the issuer.
Nominal Yield - Definition and real rate of return
This bond interest rate is what the issuer pays to par value (amount of bonds owned). It is fixed and never changes during the life of the investment.
This is different than the yield to maturity or the current yield if the price paid for the security is lower or higher than par.
Premium and Discounts vs. Nominal Yield
The nominal yield is not always your overall rate of return on a security - it usually is not. When someone buys a bond at a premium, their total rate of return will be lower than the coupon rate. Since the interest is only paid to par, the premium (amount above par) is lost over the life of the security. This will give the investor a lower yield to maturity.
If a person buys a corporate bond at a price of $98.50 and the nominal rate is 3%, the investor is actually paying 985.00 per $1000 bond. They will be paid 3% on the par value $1000 per year, but since only 985.00 was invested and they are getting $1000 back at maturity (all bonds mature at par), their YTM will be higher than 3%. If a bond is held to the end, the yield to maturity
is it's true rate of return - not the nominal yield.
A 12% bond pays 12% of $1,000, or $120 for every $1,000 of
principal each year. The bondholders
receive $60 in interest every six
months, plus the principal payment at the bondís maturity.
Current Interest Rates
Current interest rates will dictate where the nominal rate is set. There are also other factors that will determine it. These include:
- Maturity length and where the yield curve is
- Bond Rating - an issuer with a lower credit rating will have to offer a higher nominal yield or issue the bond as an OID - Original issue discount
- Interest Payment Frequency
- Type of bond - Municipal, Corporate or other
- Callable or non callable
Call - Callable
Bonds with a nominal yield will pay that fixed rate to par, but that will only last as long as the bond is active. If there is a call feature on the bond, it could get
called early and your nominal rate or YTM will not be realized. You will then receive as your rate of return, the yield to call
Bonds with higher coupon rates also get called first, since their interest rate is higher than the market. When issuers examine their fixed income debt securities, the true interest cost to them regardless of price is the coupon rate. That is why the higher nominal yield issues will see a call first.
Think of the issuer as a homeowner looking refinance their mortgage when interest rates decline. Bonds are debt. The nominal rate is the same as any fixed loan you have.
The yield to call is also usually lower with higher coupon issues since those are noramlly bought at a premium and many bonds are called at par or slightly over par. If the call price (the price it costs the issuer to redeem) is lower than the price paid by the investor, the yield to call is lower. If a nominal yield is low, the YTC may not be lower but lower coupon securities are not called as often so the higher yield to call is many times at best hypothetical given the lower interest rate.
Higher bond coupon rates will provide more current income to the investor, so as far as income - higher is better. As far as real rate of return (discounting inflation, reinvestment risk etc.), it is not always better to chase the highest nominal coupon.
You have to look at the overall picture of a bond as discussed above. In the end, the YTC or the YTM is usually your true yield.
So the true definition of the nominal yield is simply the fixed coupon rate paid to par, which never changes.
Copyright American Investment Training, Inc. Bond Yield education - yield to maturity and nominal yield training