What It Is:

Also called the equivalent bond yield, the CER is the effective yield on a zero-coupon bond as if it paid a coupon.
 
The formula for CER is:

(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.

How It Works/Example:

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 bond. The current price of the zero-coupon bond 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 essentially pays a higher interest rate.

Why It Matters:

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, this interest accrues over time and 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 the investor typically receives more than what he or she invests when the bond matures.
 
Thus, the CER uses the investor's actual initial investment as a basis for calculating yield, and ultimately it allows the investor to compare yields from zero-coupon with bonds that pay coupons.