[Bloomburger]

I'm having trouble understanding this concept.


Say you have two different bonds to chose from. One is a zero coupon bond and another one is a standard coupon bond. For the sake of this question, disregard tenor (maturity).

Now considering what Bernanke said yesterday, (that the Fed will be doing their best to keep the interest rate as low as possible), what is the better choice?

I am told the answer is obvious, but I can't see it..


If the Fed is trying to keep interest rates as close to 0 as possible wouldn't there be very little reinvestment risk?


I must be misunderstanding the difference between zero coupon bonds and regular bonds. So here is what I currently believe they each mean. If I am misunderstanding one of these terms, than that is probably why I am not getting the answer.


Zero coupon bonds, well, don't pay coupons, or interest. At maturity you are repaid the price of the bonds plus some interest you would have accumulated if it were a coupon bond.

EX: Pay $100 for a zero coupon bond. After 1 year, at maturity, you are paid $105.

My understanding of a regular coupon bond is again best described in an example.

EX: Say interest rates are 5%. You buy coupon bond for $100. You are paid $5 after the first 6 months, this is your coupon payment. The $5 that you received after the first 6 months is reinvested (?I am confused on this, what does this mean? Re invested into what?) and receives the same interest rate as the current market. So lets say 6 months after purchasing your bond the IR is now 20%. So your $5 gets an interest rate of 20% for the next 6 months until maturity. 12 months after you have purchased your bond and it has hit maturity you are paid back your initial investment of $100 + $6 = $106. This 6$ because the coupon (interest) payment received 20% interest over the 6 months since you received it.



Is this correct? Are coupon bonds priced the same as regular fixed coupon bonds? Just paid in a different way?

[Bloomburger]

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[Elitny]

Originally Posted by Bloomburger »

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A better example is lets say you have a bond with a 5 year YTM, that is priced at lets say 2 percent interest (rr) with a 6 percent coupon rate and a 1000 face value. The PV of said Bond is = 1188.5 meaning it is selling at a premium

Same bond with no coupon rate has a PV of 905.73


So in other words a bond with a coupon rate will trade at a higher rate. Also to your question of re-investment it means that in an ideal world your coupon would have to return the same amount as the interest rate on the bond.

[Bloomburger]

Originally Posted by Elitny »

A better example is lets say you have a bond with a 5 year YTM, that is priced at lets say 2 percent interest (rr) with a 6 percent coupon rate and a 1000 face value. The PV of said Bond is = 1188.5 meaning it is selling at a premium

Same bond with no coupon rate has a PV of 905.73


So in other words a bond with a coupon rate will trade at a higher rate. Also to your question of re-investment it means that in an ideal world your coupon would have to return the same amount as the interest rate on the bond.

I'm still not understanding the first part. What exactly does it mean for the bond to have 2 percent interest with a 6 percent coupon rate?
How did you get the number 1188.5?

And how did you get the number 905.73 for a bond with no coupon?

Thanks

[Elitny]

Originally Posted by Bloomburger »

I'm still not understanding the first part. What exactly does it mean for the bond to have 2 percent interest with a 6 percent coupon rate?
How did you get the number 1188.5?

And how did you get the number 905.73 for a bond with no coupon?

Thanks

The quoted interest rate (discount rate or intrinsic value) is how you find whether or not the bond is selling at a premium or discount to par, while the coupon rate is the payment you receive per period specified by the particular bond. Bond Value = PV of Coupons + PV of par (face)

The return on a zero coupon bond comes from the appreciation in its price rather than the payments received per period.

Also recall that the Yield to Maturity only holds constant if you are able to re-invest the coupon payments at the YTM rate, (discount rate that equates fv cash flows to current price)