Interest is the sum charged by lenders for the use of heir money. An interest rate is interest expressed as a percentage per year. However, the stated interest rate may not tell an investor how much her investment actually earns. In finance, the stated rate of interest is called the nominal interest rate. It’s important for any investor to understand the definition of nominal interest rates, and how to analyze them to determine the actual return.
The term "nominal interest rate" works in two ways. First, it can apply to the base interest rate paid without allowing for compounding of interest. For example, the nominal rate of interest for a CD might be 4.0 percent. However, if the interest is compounded, the actual annual yield will be higher. The second meaning of "nominal interest rate" refers to the rate before adjusting for inflation or credit risk. That is, the nominal rate is viewed as an aggregate including the “real rate of interest,” an inflation premium and the estimated risk to the lender.
The real rate of interest is the return lenders expect for the use of their money if the loan carries no risk and there is little to no inflation. An inflation premium is added to this. When inflation is expected to be significant, lenders face a potential loss, because the money that will be used to repay the loan will have declined in value. The inflation premium compensates for this projected loss. Finally, the lender must evaluate the credit risk posed by the borrower. The greater the risk, the more the lender will charge in interest. The sum of these factors is the nominal interest rate.
You can compute an estimate of each component of the nominal interest rate by using the prevailing rates for U.S. Treasury inflation-protected securities (TIPS), U.S. Treasury Bonds, and non-government bonds with identical maturities (10-year securities are usually used). TIPS carry virtually no risk, and are adjusted annually to offset inflation, so their interest rate is a good approximation of the real interest rate. Treasury bonds carry negligible risk, but are not inflation-protected. Subtracting the TIPS rate from the Treasury bond rate provides an estimate of the inflation premium. The non-government bond rate is a nominal interest rate. Find the credit-risk portion of the nominal interest rate by subtracting the U.S. Treasury bond rate from this interest rate.
For investors seeking a fixed income, getting a high nominal interest rate must be balanced against inflation risk and credit risk. TIPS bonds, which can be bought through mutual funds or directly from the U.S. treasury, are a way to eliminate inflation risk. The coupon rate (interest) may be low. However, the face value of a TIPS bond is tied to the Consumer Price Index that measures inflation. If the inflation rate for the year is 5 percent, the face value of the bond will be increased by 5 percent. The limitation investors must consider is that the short-term fixed income from a TIPS bond is lower than from other types of bonds.
When you are evaluating fixed-income securities other than government bonds, the nominal interest rate will vary depending on the credit risk associated with the issuer of the bond. The lowest-risk corporate and municipal bonds have the highest ratings from services like Moody’s and Standard & Poor’s. These “blue-chip” bonds provide good income at a relatively low credit risk, but do carry an inflation risk. Bonds with higher nominal interest rates can be expected to have a greater credit risk. The investor must decide how much risk to accept in exchange for higher returns.