What is nominal yield?
We use the following Qantas fixed rate bond to illustrate yield concepts. (Note that the calculations and terminology can be different for floating rate notes).
The nominal yield is the return based on annual coupon payments as a percentage of the face value of the security. Also known as the coupon rate, this does not change throughout the life of the security.
For example, the above Qantas 6.5% fixed rate bond will pay a coupon of $6.5 a year based on a $100 (face value) investment.
Coupon payments are made at regular intervals by the issuer to the investor, normally expressed as a percentage per annum. Coupons can be fixed or floating. This means they are either a set or fixed interest rate determined at the time of issue of the security, or they can vary with respect to some form of floating benchmark, normally the bank bill swap rate (BBSW). Coupons are normally paid on either a quarterly, semi-annual or annual basis.
Australian floating rate bonds generally pay a quarterly coupon while fixed rate bonds mostly pay a semi-annual coupon. Fixed rate bond semi-annual coupon payments are a flat annual coupon payment divided by two. There is no adjustment for the number of actual days in the coupon period. So if the coupon is 6.5% paid on a semi-annual basis, the holder receives $3.25 per $100 of face value every six months.
What is Running Yield?
Running yield uses the current price of a bond instead of its face value and represents the return an investor would expect if he or she purchased a bond and held it for a year. It is calculated by dividing the coupon by the market price.
For example, if you purchase the Qantas bond for the current market price (‘capital price’) of $103.64 and this bond pays a coupon of 6.5% (‘nominal yield’) on the face value ($100), you will receive a cash flow of $6.5 a year. Given this return is achieved with a premium outlay, namely $103.64, instead of $100 face value your actual return will be less than 6.5%. Therefore your running yield would be 6.27% (6.5/103.64 x 100 = 6.27). As the bond price increases, running yield decreases and as the bond price decreases the running yield would increase. Likewise if a fixed rate bond is trading at a discount the running yield will be higher than the nominal yield and if it is trading at a premium, as is the case in the Qantas example above, then the running yield is lower than the nominal yield.
What is Yield to Maturity?
The yield to maturity refers to how much a security will earn if it is held to its maturity date. It is the annualised return based on all coupon payments plus face value if you hold the security until maturity or the market price if it was purchased in the secondary market. It includes any gain or loss if the purchase price was below or above the face value. For this reason, the yield to maturity is considered the most important variable of bond analysis because it provides a basis for comparison between different securities and other interest rate based products.
If a bond is trading at a discount the yield to maturity will be the running yield PLUS the annualised capital gain between the current market price and $100 face value that will be returned upon maturity and adjusted for discounting or the time value of money. However, if a bond is trading at a premium the yield to maturity will be the running yield LESS the annualised capital loss being the difference between the current market price and $100 face value that will be returned upon maturity and adjusted for discounting.
For example, the Qantas fixed rate bond currently has a nominal yield of 6.5%, a maturity of 27 April 2020 and is currently trading at a premium to face value at around $103.64. If we calculate yield to maturity we find yield to maturity is 5.85% compared to the coupon rate of 6.5%. This means that the effective return over the life of the security if bought today would be 5.85% taking into account the current premium price of the security.
If you’d like more information please call 1800 01 01 81. All prices and yields are accurate as at 28 May 2013 and are a guide only, subject to market availability. FIIG does not make a market in these securities.
We invite readers to send any questions they have to thewire@fiig.com.au and each week we will endeavour to answer the most common queries.
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