Abstract
Pre-funded coupon 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 pre-funded coupon 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 pre-funded 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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Notes
- 1.
See Goodman and Cohen (1989) for detailed discussion of paid-in-kind bonds.
- 2.
Bierman (2005) cites some of the recent examples of bond interest collateralization and investor’s perspective.
- 3.
See Ross et al. (2010) for algebraic expression of PVIFA.
- 4.
This is analogous to a situation in portfolio construction. Consider two assets with standard deviations 10% and 20%. For an investor who is long on both assets, the portfolio standard deviation will be between 10% and 20%. However, if the investor is short on first asset and long on the second asset then portfolio standard deviation will exceed 20%.
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Srivastava, S., Hung, K. (2022). Pre-funded Coupon and Zero-Coupon Bonds: Cost of Capital Analysis. In: Lee, CF., Lee, A.C. (eds) Encyclopedia of Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-91231-4_4
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DOI: https://doi.org/10.1007/978-3-030-91231-4_4
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