Effective Yield
Candlefocus EditorAn effective yield is the total return earned on a bond, accounting for the effect of cash flows that are reinvested at the same rate during the holding period. If the coupon payments are reinvested, the effective yield of a bond is usually higher than its nominal (stated coupon) yield. To compare the bond's effective yield and its yield-to-maturity, the effective yield must be converted to an effective annual yield. It is important to note that this conversion is not necessary when comparing one bond to another.
When analyzing different bonds, evaluating the effective yield is an important factor to consider. Bonds with effective yields that are higher than the bond's yield-to-maturity are often seen as mini investments, since the higher yield is associated with investing in a bond that trades at a premium—if the bond is trading at a discount, the effective yield will be lower than the yield-to-maturity. Likewise, any bond purchased at a discount will generate a higher effective yield as the entry price would be lower.
In summary, effective yield is a useful measure for comparing the expected return of bonds invested at different prices. While nominal yield reports only the stated coupon rate, effective yield takes into account any cash flows that are reinvested. It is therefore important to know the current market value of a bond, in order to properly calculate its effective yield.