How come for series EE bonds purchased 1997 or after, the yield is lower than the rate (as of Dec '06)?

Question

If yield is determined based on the rate and the frequency of compounding shouldn't yield be the higher of the two? What is the frequency of compounding for these bonds?

Answer 1

"Plain Vanilla" bond yields (no embedded options) are dependent upon three things:

1) Price that the bonds were issued.
2) Coupon rate of the bond
3) Compounding rate

EE Bonds compound interest semiannually (every 6 months). When a bond is issued at "par" (i.e. face value), the coupon's APY (APR divided by two, add one, squared, then subtract one) will equal its yield. When the coupon's APY is lower than the yield, the bond was issued at a discount. The capital appreciation from a discount back to par at maturity is where yo pick up the extra yield. When the coupon's APY is higher than yield, the bond was issued at a premium. The amortization of the premium back to par is why coupon rates are higher than the yield.