4.2.5. Types of Yields
The nominal yield on a bond, also known as the interest rate or coupon rate, is the percentage of par value received annually as payment for the loan. Because coupon payments usually are made semiannually, the annual coupon payment generally comes in two installments.
Example: What are the interest payments on an 8% bond? Recall that corporate bonds have a par value of $1,000. For an 8% bond, the annual interest payment is 0.08 × $1,000 = $80. Because coupon payments are typically made twice a year, the investor will receive $40 every six months.
Market interest rates are constantly changing and may change dramatically during the life of a bond, but the nominal yield (NY) of a bond will always reflect the interest rate stated on the bond certificate. Suppose you want to sell your 6% bond in the market, and similar bonds are being issued today at 8%. No one is likely to pay $1,000 to receive 6% ($60 per year) when they can lend the same amount at 8% and receive $80. Your bond will not attract potential investors unless you offer to sell the bond at a discount, that is, below its par value. A bond that sells below its par value is called a discount bond.
Investors who purchase a discount bond will receive periodic payments at that bond’s coupon rate, which is lower than the nominal yield for a similar bond issued in today’s market. The benefit of such a bond, however, is that investors receive the face value of the bond when it matures, which is greater than the price they paid for it.
In contrast to a discount bond, a premium bond is a bond sold above its par value. Suppose interest rates have fallen to 4% and you hold a 6% bond. You’re not likely to be interested in selling such a bond and giving up its higher interest rate without receiving some sort of incentive, such as a premium above the stated value of the bond.
Current yield is a snapshot approximation that represents the return an investor migh