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Effective Annual Yield: Definition & Formula

Instructor: Michelle Reichartz

Michelle has lead multiple training initiatives and has a master's degree in Business Administration.

In this lesson, you will learn what effective annual yield is, how it can be calculated, and the reason it is so important when it comes to understanding bonds.

How Much Did I Earn?

Bonds can be a complicated form of investment. How much interest are you going to earn throughout the year? What amount can you expect at each payment? Each of these is going to take a certain amount of calculating, but when those interest payments are paid out the bigger question comes up. What is your actual rate of return?

This is where effective annual yield comes in.

Understanding Bonds

Before we get into understanding effective annual yield, it is essential that you understand what bonds are and how they work. Bonds are a type of security that require the issuer to pay the bondholder an interest payment at specific intervals throughout the year until the principal amount is repaid to the bondholder.

These bonds can be issued by anyone, but are most often issued by the United States Government, their agencies, states, cities, and even corporations. Sole proprietors do not usually issue bonds since they are expensive to issue, along with being very complicated.

Bonds are an excellent form of investment. They provide a way to diversify the investments you make, along with a continuous form of income. Bonds can also be tax-exempt, depending on how the bond was issued.

Effective Annual Yield's Calculation

Now that we have thoroughly explained bonds, let's discuss effective annual yield. Effective annual yield is the most accurate method for determining your rate of return as the bondholder. By taking compounding into account, it provides the real return rate. Coupon is the annual interest payment made on a bond.

Let's look at an example:

Acme, Inc. has issued a 30-year bond with a coupon at 8%. The interest is paid out quarterly.

You are one of the bondholders and would like to know just how much interest you are really receiving each year.

The formula for calculating Effective Annual Yield (EAY) is: (1 + (i / n))n - 1

The i stands for your interest rate while the n stands for the number of payment periods in a year.

In our example, the i is .08 while the n is 4.

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