What Is the Effective Yield?
Let me explain effective yield directly: it's the return you get on a bond when you reinvest its interest payments, or coupons, at the same rate. This gives you the total yield you'll receive, unlike the nominal yield, which is just the bond's stated coupon rate. Effective yield factors in compounding on your investment returns, something nominal yield ignores.
Key Takeaways
You calculate effective yield by dividing the bond’s coupon payments by its current market value. It assumes you reinvest those coupons, so the effective yield ends up higher than the nominal yield due to compounding. When comparing effective yield to yield-to-maturity, convert it to an effective annual yield. If a bond's effective yield is higher than its yield-to-maturity, it sells at a premium; if lower, it trades at a discount.
Understanding Effective Yield
Effective yield measures the coupon rate, which is the interest rate on the bond as a percentage of its face value. Issuers pay these coupons semi-annually to you, the investor, meaning two payments per year. You figure it out by dividing the coupon payments by the bond's current market value.
This is one method to measure your bond yields. There's also current yield, which is the annual return based on annual coupons and current price, not face value. Unlike effective yield, current yield doesn't assume reinvestment of coupons.
The main issue with effective yield is it presumes you can reinvest coupons at the same interest rate, and that bonds sell at par. That's not always realistic, as interest rates fluctuate with economic factors.
Effective Yield vs. Yield-to-Maturity (YTM)
Yield-to-maturity is the return you earn if you hold the bond until it matures. To compare it with effective yield, convert YTM to an effective annual yield. If YTM is greater than effective yield, the bond trades at a discount to par. If YTM is less, it's at a premium.
YTM is a bond equivalent yield. For a more precise annual yield, account for the time value of money to get the effective annual yield.
Example of Effective Yield
Suppose you hold a bond with a $1,000 face value and a 5% coupon paid semi-annually in March and September. You'll get (5%/2) x $1,000 = $25 twice a year, totaling $50 in coupons.
Effective yield assumes you reinvest those payments. This makes your yield higher than the current or nominal yield because of compounding—interest on interest. You'll end up with a bit more than $50 annually.
The formula is i = [1 + (r/n)]^n – 1, where i is effective yield, r is nominal rate, and n is payments per year. For this 5% bond: i = [1 + (0.05/2)]^2 – 1 = 1.025^2 – 1 = 0.0506, or 5.06%.
That's higher than the 5% coupon due to compounding. Breaking it down: In March, you get 2.5% x $1,000 = $25. In September, it's 2.5% x $1,025 = $25.625. Total: $50.625, so $50.625/$1,000 = 5.06%.
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