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?