Cash Backed Bonds - Myths

The concept of cash-backed bonds—bonds fully collateralized by cash—seems counterintuitive and economically redundant. Here’s why such instruments generally do not make financial sense:
 

1. Bonds Exist to Raise Capital – Holding Cash Defeats the Purpose 

Bonds are traditionally issued by corporations, governments, or institutions as a means of raising capital. Investors lend money to the issuer in exchange for periodic interest payments and the return of principal at maturity. 

  • If the issuer already has the cash required to fully back the bond, then why issue the bond in the first place? 
  • The issuer could simply use the cash for its intended purpose rather than creating an unnecessary financial instrument. 

 

Analogy: Imagine taking out a loan while simultaneously keeping an equal amount of money in a savings account earning a lower interest rate than the loan. It’s financially inefficient. 

 

2. Negative Carry: The Issuer Would Lose Money 

Bonds cost money to issue because they require paying interest to bondholders. If a bond is fully backed by cash, this results in a negative carry: 

  • The issuer would need to pay a coupon rate on the bond. 
  • However, the cash sitting as collateral would likely earn a lower return (or no return at all). 
  • The spread between the coupon payments and the return on the idle cash results in a guaranteed loss. 

 

Example: 

• A corporation issues a $100 million cash-backed bond at a 5% annual interest rate. 

• The $100 million sits in a bank account earning only 2%. 

• The corporation is losing 3% annually for no apparent reason. 


 

3. No Additional Creditworthiness is Gained 

One might argue that cash backing improves creditworthiness. However, in practice: 

  • Investors buy bonds based on the issuer’s ability to generate future cash flows (profits, tax revenue, etc.). 
  • If the issuer already has enough cash to back the bond, investors would simply demand access to that cash rather than buying a bond backed by it. 
  • A cash-backed bond doesn’t add value to the investor beyond holding cash directly. 

 

Conclusion: Investors prefer bonds to be backed by assets that generate economic activity—not idle cash. 

 

4. Issuers Could Simply Issue a Zero-Coupon Bond Instead 

If an entity has cash but wants to issue bonds for financial structuring reasons (e.g., managing liabilities), a zero-coupon bond would be far superior. Instead of paying periodic interest, it’s sold at a discount and redeemed at face value, allowing for cash efficiency

 

5. Central Banks and Sovereigns Don’t Need Cash-Backed Bonds 

For governments, issuing cash-backed bonds makes even less sense: 

  • Governments issue bonds to finance deficits—not to park cash. 
  • If a government has the cash, it can simply spend it instead of issuing debt. 
  • Central banks control monetary policy and don’t need to collateralize their bonds with cash. 


 

Summary: A Redundant, Costly, and Inefficient Structure 

A cash-backed bond is self-defeating because: 

  1. It defeats the purpose of issuing a bond (which is to raise capital). 
  2. It creates unnecessary financial costs (negative carry). 
  3. It does not improve creditworthiness (investors would prefer direct access to the cash). 
  4. It can be replaced by more efficient financial instruments (such as zero-coupon bonds or direct spending). 

 

Thus, cash-backed bonds are economically illogical and financially inefficient in almost all scenarios. 

Here’s an overview of the main types of financial bonds:

  1. Government Bonds: Government bonds are issued by national governments to finance public spending and are generally considered low-risk investments.
  2. Treasury Bonds: Issued by the U.S. government, these include Treasury Bills (short-term), Treasury Notes (medium-term), and Treasury Bonds (long-term).
  3. Eurozone Government Bonds: Issued by EU member states, such as German Bunds, French OATs, and Italian BTPs.
  4. UK Gilts: Issued by the UK government, similar to U.S. Treasury bonds but specific to the UK market.
  5. Sovereign Bonds: Issued by governments outside the Eurozone and UK, including emerging market bonds.
  6. Municipal Bonds: Municipal bonds are issued by local governments, regions, or cities to fund public projects. They often offer tax advantages, making them attractive to investors in higher tax brackets.
  7. Corporate Bonds: Corporate bonds are issued by companies to raise capital for various purposes.
  8. Investment-Grade Corporate Bonds: Issued by financially stable corporations with higher credit ratings.
  9. High-Yield Corporate Bonds: Also known as “junk bonds,” these are issued by companies with lower credit ratings and offer higher yields to compensate for increased risk.


Specialized Bonds

  1. Zero-Coupon Bonds: These bonds don’t pay periodic interest but are sold at a discount to their face value, which is paid at maturity.
  2. Convertible Bonds: These bonds can be converted into a predetermined number of shares of the issuing company’s stock.
  3. Callable Bonds: These allow the issuer to redeem the bond before its maturity date.
  4. Puttable Bonds: These give the bondholder the right to force the issuer to repurchase the bond before maturity.
  5. Floating-Rate Bonds: These bonds have variable interest rates that adjust periodically based on market conditions.


Other Types

  1. Agency Bonds: Issued by government-sponsored enterprises or supranational institutions.
  2. Asset-Backed Securities: Bonds backed by underlying cash flows from other assets, such as mortgages.
  3. Inflation-Linked Bonds: These bonds offer returns indexed to the inflation rate.
  4. Green Bonds: Issued to fund environmentally friendly projects.
  5. Social Impact Bonds: These are agreements where public sector entities pay back private investors after meeting verified improved social outcome goals.


Each type of bond offers different levels of risk, return, and features, catering to various investor needs and market conditions. Understanding these different types is crucial for building a well-rounded investment portfolio and managing risk effectively.

Those bonds could be considered similar to the so-called or intended "Cash Backed Bonds" are:

Asset-Backed Securities (ABS)

While not specifically “cash backed,” asset-backed securities are a type of bond that is backed by a pool of underlying assets:

  •  ABS are securities whose income payments and value are derived from and collateralized by a specified pool of underlying assets.
  • These assets can include various types of loans, such as auto loans, consumer loans, and credit card receivables.
  • The cash flows from these underlying assets are used to pay interest and principal to the bondholders.


Covered Bonds

Covered bonds are another type of bond that, while not explicitly “cash backed,” have some similarities:

  •  They are derivative instruments consisting of a package of loans issued by banks.
  •  The loans are collateralized against a pool of assets, providing an additional layer of security for bondholders.
  •  Covered bonds offer dual recourse: against the issuer of the bond and against the assets of the bank that issued the underlying loans.