What is a Coupon Equivalent Rate (CER)?
The coupon equivalent rate (CER), also known as the bond equivalent yield (BEY), is the effective yield on a zero-coupon bond when calculated as if it paid a coupon.
How Does a Coupon Equivalent Rate (CER) Work?
To calculate the coupon equivalent rate, use the following formula:
(Spread between current price and face value / current price) x (365 / time to maturity)
note that some versions of the formula use a 365-day year while others use 360-day year. Both methods are very common.
Let's assume you have a choice between purchasing a $10,000 XYZ Company bond that pays a 5% coupon and matures in 90 days or purchasing a $10,000 zero-coupon bond from Company ABC.
The current price of the zero-coupon bond (issued by ABC) is $9,850, it matures in 90 days, and has a $10,000 face value. Which bond pays a higher interest rate?
Using the formula above, we can calculate that the CER of the ABC bond is:
($150/$9,850) x (365/90) = .061759 = 6.18%. By comparing this 6.18% with the 5% interest paid on the XYZ Company bond, we can see that the Company ABC bond pays a higher effective interest rate.
Why Does a Coupon Equivalent Rate (CER) Matter?
Typically, an investor in coupon-paying bonds calculates his or her yield based on the coupon rate and the face value of the bond. But these two bases do not apply to zero-coupon bonds.
Although it is important to remember that zero coupon bonds do pay interest, but the issuer pays it out upon maturity instead of every six months. Also, zero-coupon bonds are not sold at face value; they are sold at a discount, and at maturity the investor typically receives more than what he or she invested.
Thus, the CER uses the investor's actual initial investment as a basis for calculating yield, allowing the investor to compare yields from zero-coupon with bonds that pay coupons.
