What is Effective Annual Yield?

An effective annual yield is defined as the total profit or returns on a bond that an investor receives. An effective annual yield differs from nominal yield or coupon rate on a bond. While nominal yield covers the interest rate par value that an investor receives from the bond issuer, an effective annual yield takes into account compound interest earning or compound investment returns.

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How Does Effective Yield Work?

Effective annual yield is the annual interest rate or rate of return that an investor in entitled to over a period of time. There are many ways to measure effective yield, these include;

• The measuring the coupon payments on bond or the percentage on the par value of bonds.
• By dividing coupon payments on the bond by the current market value of the bond.
• By calculating Yield to maturity (YTM) which is the rate of return that an investor or bondholder earns until the bond matures.

When coupon payments are reinvested, the measurement of the return on bond they have is the effective yield. Coupon payments are made twice a year, effective yield is more than nominal yield or coupon yield. The formula for calculating effective yield is; Where i = effective yield, r= nominal yield or coupon yield and n=number of coupon payments per year. Basically, coupon payments are made twice a year, if a bond has a par value of $1000 and the coupon rate in 10%, a total amount of 50% will be collected as coupon payment for a year. The effective yield that an investor can realize form the above coupon payment will be calculated as follows; i = [1 + (0.10/2)] 2 1 i = 1.052 1 i = 0.1025, or 10.25% Effective yield often holds that the reinvestment of coupon payments are the current rate but this is not always the case due to fluctuations and variable factors that affect interest rate.