What is Effective Yield?
The effective yield is the return on a bond that has its interest payments (or coupons) reinvested at the same rate by the bondholder. Effective yield is the total yield an investor receives, in contrast to the nominal yield—which is the stated interest rate of the bond’s coupon. Effective yield takes into account the power of compounding on investment returns, while nominal yield does not.
The effective yield is calculated as the bond’s coupon payments divided by the bond’s current market value
Effective yield assumes coupon payments are reinvested. Reinvested coupons mean the effective yield of a bond is higher than the nominal (stated coupon) yield.
To compare a bond’s effective yield and its yield-to-maturity, the effective yield must be converted to an effective annual yield.
How Does Effective Yield Work?
There are many yields or returns that a bond or an investment can accrue. There are a number of ways to measure yields on bond, this includes, yield to maturity (YTM), bond equivalent yield (BEY) and the effective yield. The effective yield is a measure of yield that a bond has if its coupon payments are reinvested and also yield earnings.
Generally, investors receive coupon payments on bonds twice a year, if the coupon payments are reinvested, the total yield is the effective yield. For example, if an investor receives a coupon payment of 5% on $2, 000 and the coupon payment is paid twice a year, that is $50*2 = $100, the total earnings of the coupon payments when they are reinvested is the effective yield. Below is the formula for calculating effective yield; i = [1 + (r/n)]n 1.
In this formula (i) represents effective yield, (r) means nominal rate and (n) means number of payments per year. Usually, the effective yield of a bond is higher than the coupon or nominal yield of the bond, this is because of compounding effect. The effective yield is only calculated on a bond whose coupon payments are reinvested.
If a bondholder is perceived to reinvest the interest of the bond, the effective yield of the bond is therefore estimated. This illustration is helpful to the understanding of how effective yield is calculated; If a bondholder receives a 5% coupon payment of a bon worth $2,000, the coupon payment is made twice a year and that gives the bondholder $50*2 as the annual coupon payment.
If the bondholder reinvests the coupon payments, he will also receive interest on the reinvested value through compounding. The total yield on this type of bond is however higher than the nominal yield or coupon yield, hence it is regarded as effective yield. Therefore, effective yield is calculated based on the assumption that coupon payments can be reinvested and accrue the same interest as the original investment. This assumption is plausible is bonds are being sold at par but this is not always the case.
Formula for Calculating the Effective Yield
The formula for calculating the effective yield on a bond purchased:
Effective Yield = [1 + (i/n)]n – 1
- i – The nominal interest rate on the bond
- n – The number of coupon payments received in each year
Effective yield is also termed as annual percentage yield or APY and is the return generated for every year. Its formula is i = [1 + (r/n)]n – 1.
This method is highly preferred by most of the investors since the method, unlike all other methods, takes compounding into its due consideration and also assumes that the investors are eligible for reinvesting their coupon payments at the coupon rates.
This method is way different from the nominal method, and hence, the two must not be confused with one another. If the payments received from the bonds are invested again, then the effective yield of an investor shall be higher than the nominal yield or mentioned coupon yield as a result of compounding.