The effective yield of a bond takes compounding into account. Compounding interest payments allow a higher yield, or interest rate, because the payments are reinvested into the interest-generating bond amount. Effective yield is an annual rate that can be conveniently used to compare bonds with different time periods between interest payments. This is not applicable to all bonds, however, because reinvestment of interest is not always allowed.
A bond is a form of debt security between an issuer and a holder. The issuer is borrowing money and paying regular interest payments for the privilege of borrowing. The holder is lending money and is collecting interest payments for the inconvenience of lending. The terms of the bond specify the various details of the debt, such as the amount to be borrowed, the total borrowing time and the interest rate. Another important term of a bond is how often interest is paid is whether these payments are reinvested into the bond.
When reinvesting occurs, interest payments become a part of the money owed to the holder and are subject to the interest rate. The more frequently interest is compounded, the more interest will be generated. In other words, shorter periods between interest payments will result in more interest. It is possible for interest to compounded continuously, but this practice is rarely used for bonds. Rather, bonds often offer interest payments twice a year.
Although time periods between interest payments can vary, it is often convenient to compare bonds in terms of their annual interest rate. This is where the effective yield can be useful. Without calculating the effective yield, it is difficult to account for the effect of reinvestment.
The effective yield can be found with the following formula:
[1+(i/n)]^{n} - 1
In this equation, i is the original annual interest rate and n is number of payments per year. An effective yield will generally be slightly higher than the original yield. It is a more accurate measure of a bond’s interest rate, which can have a significant effect over the long term.
Reinvestment of interest payments is not always allowed in a bond. The value of a bond is highly dependent on future inflation rates, which cannot be fully predicted. In particular, a falling inflation rate will be favored by the holder of the bond. This is because interest payments will have more purchasing power in an environment with lower inflation. Thus, if an issuer suspects inflation rates to fall, he may be wary of issuing a bond with reinvestment in the terms.