What is effective annual yield and when do I use it?

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AcadiFi · Accepted Answer

Effective annual yield (EAY) is the yield a bond would earn if compounded once per year, accounting for all intra-year compounding. It's the single 'true' annualized yield used for apples-to-apples comparisons. Formula: EAY = (1 + periodic rate)^m − 1, where m = compounding periods per year. Example: A semi-annual bond with YTM (BEY) = 6.40%: periodic rate = 3.20%, EAY = (1.032)^2 − 1 = 6.5024%. A quarterly-pay bond with APR 6.35%: periodic rate = 1.5875%, EAY = (1.015875)^4 − 1 = 6.5025%. Both bonds therefore have essentially identical effective yields despite different quoted conventions. Another example: A CD quotes 5.10% APR with monthly compounding. EAY = (1 + 0.051/12)^12 − 1 = (1.00425)^12 − 1 = 5.2198%. A Treasury at BEY 5.18% has EAY = (1.0259)^2 − 1 = 5.247%. The Treasury wins despite a lower quoted number. When do I use EAY? (1) ranking bonds with different compounding conventions; (2) comparing bonds to non-bond instruments (CDs, money-market funds, dividend stocks); (3) computing realized yield over multi-year holding periods; (4) inputting into risk measures that require annualized inputs. Exam pitfall: EAY is NOT the same as YTM unless the bond is annual-pay. For semi-annual bonds, EAY is always slightly higher than BEY due to intra-year compounding.

What is effective annual yield and when do I use it?

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