Title: Are pre-funded bonds good substitutes for zeros in corporate financing?

Authors: Ken Hung; Shinhua Liu

Addresses: Sanchez School of Business, Texas A&M International University, Laredo, TX 78041, USA ' School of Business, University of Texas at Brownsville, Brownsville, TX 78520, USA

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-à-vis a zero-coupon bond.

Keywords: pre-funded bonds; zero-coupon bonds; Macaulay's duration; interest subsidies; interest risk; value loss; financial engineering; corporate financing; collateralised bonds; cash flow; escrow accounts.

DOI: 10.1504/IJBD.2016.081378

International Journal of Bonds and Derivatives, 2016 Vol.2 No.4, pp.365 - 378

Received: 04 Mar 2016
Accepted: 08 May 2016
Published online: 06 Jan 2017 *

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