Abstract
Collateralized 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 collateralized 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 collateralized issue. In reality, the escrow return is lower than the bond yield. As a result, the firm provides interest subsidy through issuing additional bonds which leads to higher leverage, greater risk and loss of value compared to a zero-coupon issue.
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