Abstract
Collateralised bonds have been developed and sold by investment bankers in place of zero-coupon bonds to raise funds for companies facing cash flow problems. Additional bonds are issued and proceeds are deposited in an escrow account to finance the coupon payment. Our analysis indicates that a collateralised bond is equivalent to a zero-coupon bond only if the return from the escrow account is the same as the yield to maturity of the collateralised issue. In reality, the escrow return is lower than the bond yield. As a result, the firm provides an interest subsidy through issuing additional bonds, which leads to higher leverage, greater risk, and a loss of value vis-a-vis a zero-coupon bond.
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