Investors diversify and ensure they have uninterrupted profits in every stock market scenario. Starting with equities, they move to the debt instruments such as bonds, where they know they will receive returns through a coupon rate or value appreciation. However, the investors can seem perplexed while choosing between a zero-coupon bond or a bond that pays a regular coupon. The coupon equivalent rate is used to simplify the process and allow them to choose the better between the two types of bonds.
What are Bonds?
Bonds are loan agreements between the issuer and holder, which details the terms of payment (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium. Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity.
What is Coupon Equivalent Rate?
The coupon equivalent rate is a calculation of the effective yield on a zero-coupon bond. The effective yield is the annual rate of return attached with a period of interest rate, while a zero-coupon bond is a type of bond that provides no periodic interest to the bondholders. The bondholders only profit from the gradual appreciation of the underlying security. The coupon equivalent rate is also known as bond equivalent yield (BEY) and is taken as an alternative calculation to measure the coupon rate to compare fixed-income securities and zero-coupon.
Understanding Coupon Equivalent Rate
The coupon equivalent rate allows an investor to compare the yield of a bond that pays an interest rate with one that is zero-coupon and does not pay any interest. When buying a bond, an investor has two options; to buy zero-coupon bonds that are issued at a discount to par or bonds that pay regular interest. The investors use the coupon equivalent rate formula to compare the yield or return on zero-coupon bonds and bonds that pay regular interest. When the coupon equivalent rate formula is used, the results indicate the annualised yields or returns on a short-term debt security.
In essence, the coupon equivalent rate tells the investors what the coupon rate on a discount bond would be if the bond carried an interest rate payment and was sold at face value. As the discount bonds are not issued at face value, investors tend to earn higher returns at the time of maturity. However, the quoted rate of bonds is calculated by factoring in the face value, making them inaccurate compared to other coupon bonds. Here, the best way to compare both types of bonds is to use the coupon equivalent rate formula.
The formula for Coupon Equivalent Rate
The formula for coupon equivalent rate is as follows:
Coupon Equivalent Rate = Face Value - Market Price/ Market Price x 360/Days until maturity
Example of Coupon Equivalent Rate
Suppose you have a choice of purchasing between a Rs 10,000 bond of XYZ company that pays a 5% coupon and matures in the next 90 days and a Rs 10,000 zero-coupon bond. The current price of the zero-coupon bond issued at a discount is Rs 9,850.
The investor can use the coupon equivalent rate formula to compare the bonds and know which can give you better returns. Using the formula, the results for the zero-coupon bond would be:
CER = (150/9,850)X(365/90) = 0.6175 i.e. 6.18%.
With the result, the investor knows that the zero-coupon bond will provide better returns at Rs 6.18% than the 5% coupon rate of the other bond.
Final Word
The coupon equivalent rate formula is vital for investors looking to invest in bonds and allows them to choose effectively between a zero-coupon or coupon paying bond. Now that you know the coupon equivalent rate definition, you can also choose an ideal bond with better returns.
