Constant interest rates are an impossible assumption. Forget the direction of interest rate movements, the greater convexity means that the zero coupon bond will be worth more than a coupon bond if interest rates move up OR down. For that reason, the zero coupon bond is more valuable than the coupon bond.
So if you knew interest rates would move up, you’d still take the zeros? Assume, Bond A pays 8% coupon, matures in 10 years, and is priced at $100. Then its YTM = 8% (same as the coupon rate). Assume the zero-coupon bond is priced at $45.64 to yield 8%. If interest rate shoot up to 20%, wouldn’t you be able to reinvest the coupon payments at 20% and end up having more cash at maturity than with the zero-coupon bond?
I take that back. I overlooked the fact that the duration on the zero would be considerably greater than that of the coupon bond. The convexity of the zero would actually be smaller than that of a coupon bond if you held the yield and modified duration constant. This would actually make the zero coupon bond less attractive than a coupon paying bond with the same YTM and modified duration.
Dreary…ummm who “knows” interest rates will go up?
Assume you’re Bernanke, and choose which bond! In economics, they do talk about expected and unexpected change in interest rates. Do you remember those sections?
oh yeah i forgot… since Dreary red those sections Dreary must know when interest rates will go up… nice! so can you fill us all in, please!!! I have a sweet million or two I’d like to personally make off of that trade.