What is the 'Effective Yield'

The effective yield is the yield of a bond which has its coupons reinvested after payment has been received by the bondholder. Effective yield is the total yield an investor receives in relation to the nominal yield or coupon of a bond. Effective yield takes into account the power of compounding on investment returns, while nominal yield does not.

BREAKING DOWN 'Effective Yield'

Bondholders can measure their yields on bonds in a number of ways. The current yield represents a bond’s annual return based on its annual coupon payments and current price, as opposed to the face value. It is calculated by dividing the coupon payments by the current market value of the bond. The yield to maturity (YTM) is the rate of return earned on a bond that is held until maturity. It is a bond equivalent yield (BEY), not an effective annual yield (EAY). A third measure of bond yield is the effective yield.

The effective yield is a measure of the coupon rate, which is the interest rate stated on a bond and expressed as a percentage of the face value. Coupon payments on a bond are typically paid semi-annually by the issuer to the bond investor. This means that the investor will receive two coupon payments per annum. For example, if an investor holds a bond with a face value of $1,000 and 5% coupon paid semi-annually on March and September, he will receive (5%/2) x $1,000 = $25 twice a year for a total of $50 in coupon payments.

However, the effective yield is a measure of return on a bond assuming the coupon payments are reinvested. If payments are reinvested, then his effective yield will be greater than the stated coupon yield or nominal yield, due to the effect of compounding. Reinvesting the coupon will produce a higher yield, because interest is earned on the interest payments. The investor in the example above will receive a little more than $50 annually using the effective yield evaluation. The formula for calculating effective yield is:

i = [1 + (r/n)]n – 1

where i = effective yield

r = nominal rate

n = number of payments per year

Following our initial example presented above, the investor’s effective yield on his 5% coupon bond will be:

i = [1 + (0.05/2)]2 – 1

i = 1.0252 – 1

i = 0.0506, or 5.06%

Note that since the bond pays interest semi-annually, payments will be made twice to the bondholder per year, hence, number of payments per year is 2.

From the calculation above, the effective yield of 5.06% is clearly higher than the coupon rate of 5% since compounding is taken into consideration. To understand this another way, let’s scrutinize the details of the coupon payment. In March the investor receives 2.5% x $1,000 = $25. In September, due to interest compounding, he will receive (2.5% x $1,000) + (2.5% x $25) = 2.5% x $1,025 = $25.625. This translates to an annual payment of $25 in March + $25.625 in September = $50.625. The real interest rate is, therefore, $50.625/$1,000 = 5.06%.

To compare the effective yield to the YTM, convert the YTM to an effective annual yield. If the YTM is greater than the bond’s effective yield, then the bond is trading at a discount to par. On the other hand, if the YTM is less than the effective yield, the bond is selling at a premium.

The drawback with using the effective yield is that it assumes that coupon payments can be reinvested in another vehicle paying the same interest rate. This also means that it assumes the bonds are selling at par. This is not always possible, considering the fact that interest rates change periodically, falling and rising due to certain factors in the economy.

RELATED TERMS
  1. Coupon

    A coupon is the annual interest rate paid on a bond, expressed ...
  2. Gross Yield

    The gross yield is the yield on an investment before the deduction ...
  3. Yield To Maturity (YTM)

    Yield to maturity (YTM) is the total return expected on a bond ...
  4. Short Coupon

    A short coupon is a payment made on a bond within a shorter time ...
  5. Yield Basis

    The yield basis is a method of quoting the price of a fixed-income ...
  6. Average Price

    The average price is sometimes used in determining a bond's yield ...
Related Articles
  1. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  2. Investing

    How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?

    Yield to maturity is a basic investing concept used by investors to compare bonds of different coupons and times until maturity.
  3. Investing

    How Bond Yields Could Topple the Stock Market

    Bond yields have reached a crucial point since the election that could be bad news for the stock market.
  4. Personal Finance

    6 Sneaky Ways Coupons Make You Spend More

    If you're hoping to save money by using coupons, watch out for sellers' strategies.
  5. Investing

    Corporate Bonds: An Introduction to Credit Risk

    Understand how corporate bonds often offer higher yields, and discover how it is important to evaluate the risk, including credit risk, that is involved before you buy.
  6. Personal Finance

    6 Tricks To Make Coupons Work For You

    Use these strategies to counteract the stores' and manufacturers' coupon tactics and come out ahead.
  7. Investing

    Why Investors Should Use Duration to Compare Bonds

    Duration is a helpful metric that determines a bond's sensitivity to interest rates.
RELATED FAQS
  1. What is the difference between yield to maturity and the coupon rate?

    A bond's coupon rate is the actual amount of interest income earned on the bond each year based on its face value. Read Answer >>
  2. Current yield vs yield to maturity

    Learn about the relationship between a bond's current yield and its yield to maturity, including how the market price of ... Read Answer >>
  3. If I buy a $1,000 bond with a coupon of 10% and a maturity in 10 years, will I receive ...

    See how fixed-income security investors can expect to use coupon rates on semi-annual payments if the bond or debt instrument ... Read Answer >>
  4. What is the most common solvency ratios used in fundamental analysis?

    Learn about the difference between a bond's coupon rate and its yield rate, how the coupon rate influences market price and ... Read Answer >>
  5. How does a bond's coupon interest rate affect its price?

    Find out why the difference between the coupon interest rate on a bond and prevailing market interest rates has a large impact ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center