American Investment Training

Monday, January 2, 2017

Understand Bond Yields for the Series 7 - Nominal, Current and Yield to Maturity

Most bonds are fixed income securities. They pay a stated rate of interest to par. That fixed rate is the nominal yield. The nominal yield does not change during the life of the bond. It is also known as the coupon rate. 

Bond Pricing vs. Yield

If a bond is purchased at a discount, par or at a premium, the nominal rate stays the same and the actual interest payments received are not changed as well. 

Nominal Yield Example

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.

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

Current Yield

A bond's current yield is not as important to an investor. It is not the actual interest rate received and it is not the overall yield to maturity. 

A bond's current yield can be found by dividing the coupon or nominal by the current market price of the security. It is not an overly important yield to investors - as it is always changing and is most important if someone is pricing the bond to sell. If an investor is holding the security to maturity - then the current yield is not a big concern.

A debt that is priced above par (premium) will have a lower current yield vs. the nominal. A 7% corporate debenture priced at $102 will have a current of 6.86% ($70 divided by $1020). Discounted bonds will have a higher current yield than it's coupon rate.

Yield To Maturity

To most investors, the yield to maturity is the most accurate and best measure of a bondholder's overall rate of return. 

YTM uses all the components of a bond investment to come up with a true overall yield on the security. The formula and calculation is based on the bond reaching maturity. As with most bonds, default is rare, so the real risk lies with the following:
  • Is the bond callable?
  • What price is it callable at?
  • When are the call dates?
  • Interest rates rise and bond is sold (result in loss in most cases)
  • How long is the maturity? - A bond with a Yield of 4% for 2 years is usually better than a length of 10 years in a normal or upsloping yield curve.

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