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Effective Yield Definition
The total yield of a bond when the bondholder reinvests the interest of the bond is referred to as effective yield. Effective yield is often higher than the nominal yield, this is because it is the total yield a bondholder receives on the coupons or interest reinvested. The effective yield uses the compounding effect in realizing the yield of a bond, the interest or coupon from the initial investment yields interest giving a higher yield than the nominal yield.
A Little More on What is Effective Yield
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.