Nominal yield and effective yield are two key concepts in bond investing that help investors understand the returns they can expect from their investments, but they differ in their calculations and implications.

Nominal Yield, also known as the coupon rate, is the annual interest rate stated on a bond, expressed as a percentage of its face value. For example, if a bond has a face value of $1,000 and a nominal yield of 5%, it pays $50 annually. This yield remains constant regardless of changes in the bond’s market price.

Effective Yield, on the other hand, takes into account the effects of compounding interest and the actual price paid for the bond. It reflects the bond’s total annual return, considering the reinvestment of coupon payments at the same rate. If a bond pays interest semi-annually, the effective yield will be higher than the nominal yield due to the compounding effect. For instance, a bond with a 5% nominal yield and semi-annual payments will have an effective yield slightly above 5%.

In summary, while nominal yield gives a straightforward percentage based on the bond’s face value, effective yield provides a more comprehensive picture of potential earnings by considering compounding and the purchase price. Investors use effective yield for a more accurate measure of return, especially when comparing bonds with different payment frequencies and prices.