What it is:
How it works/Example:
The formula for effective yield is:
[1 + (i/n)]n - 1
i = the nominal rate
n = the number of payment periods in one year
Let's assume you purchase a Company XYZ bond that has a 5% coupon. The nominal rate is 5%.
If the interest is paid semiannually, number of payment periods in one year is two. Using the formula above, we can calculate that the effective yield is:
[1 + (.05/2)]2 - 1 = .05062 or 5.062%
Why it matters:
Effective yield is a more accurate measure of the investor's return than calculating a simple annual interest rate (the yield for one period times the number of periods in a year) because effective yield takes compounding into account.
However, effective yield also assumes the investor can reinvest their coupon payments at the coupon rate. In our example, this means the investor can reinvest that first coupon payment in another vehicle paying 5%. This is not always possible, especially in a falling interest-rate environment. When it is, the investor can earn interest on interest, thereby raising the investor's yield above the stated coupon rate.