Definition: Bond default occurs when the issuer of the bond is unable to pay interest or principal payments on the due date. The issuer may default when they run out of cash needed to pay bondholders. Bond default is typically considered a sign of financial distress and is a last resort solution.
How Does Bond Default Work?
In the case of companies, bond default usually occurs when deteriorating conditions lead to a decline in revenue, making scheduled payments impossible. Countries are often forced to default when their tax revenues are no longer sufficient to cover debt service costs and ongoing expenses.
This issue is typically resolved through restructuring, which alters the terms of the debt. This agreement between the issuing entity and the bondholders prevents full default.
Bond default does not always mean that you will lose all of your principal. In the case of corporate bonds, you are likely to receive a portion of your principal back. This may happen after the issuer sells its assets and distributes the proceeds.
Example of a bond default: Suppose you invested in a high-yield bond with an interest rate of 9%. It has a recovery rate of 41%. You paid $100 for the high-yield bond and it defaulted. The issuer cannot pay you your principal ($100) or your interest (9% or $9). Thanks to the 41% recovery rate, you will receive $41 once the assets are distributed among creditors. Although you will still incur a loss on the investment, it is far from a total loss.
Note: When bond default occurs, it doesn’t just disappear. Bonds often continue to trade at very low prices. Sometimes they attract investors in “distressed debt” who believe they can recover more from the company’s asset distribution compared to the bond price.
Bond Default and Market Performance
Most defaults are anticipated in financial markets. This means that much of the negative impact that comes with default may occur before the default announcement. Many defaults are preceded by downgrades in the credit ratings of the issuing entity. This leads to most defaults occurring among lower-rated bonds issued by entities already known to have issues.
Between 1970 and 2021, 100% of AAA-rated municipal bonds paid all expected interest and principal installments to investors. For AA-rated municipal bonds, this was 99.9%. During the same period, only 0.08% of AAA-rated corporate bonds defaulted over a five-year period. From these figures, we can see that high-rated bonds typically do not default. This reflects the strong financial position that often accompanies a high rating.
Market Segments with High Default Risk
The risk of default is lowest for government bonds in developed markets. These include securities backed by the U.S. Treasury, as well as bonds with the highest credit ratings. Bonds that are more affected by the possibility of default than by interest rate movements are said to have high credit risk. They tend to perform well when their underlying financial strength improves but perform less when their financial conditions weaken.
Entire asset classes can be of high credit risk. They tend to perform well when the economy strengthens and may perform less when the economy slows. Key examples of this are high-yield bonds and lower-rated bonds in the investment-grade corporate and municipal category.
Measuring the impact of default risk in these market areas through the default rate in the specific asset class that has defaulted over the past 12 months. When the default rate is low or decreasing, it tends to be positive for credit-sensitive market classes; when it is high and increasing, these classes tend to lag.
What does this mean for investors?
You can avoid the impact of bond defaults by sticking to high-quality individual securities or low-risk bond funds. Active managers can avoid default risk through research. Remember that rising defaults can impact entire market classes and pressure fund returns, even if the manager can avoid the securities that default. As a result, defaults can affect all investors to some extent, even those who do not hold individual bonds.
Frequently Asked Questions (FAQs)
What rating does Standard & Poor’s assign to a bond that is in default?
Standard & Poor’s has 22 ratings for bonds. Bonds rated from CC to BB+ are considered non-investment grade. Bonds rated C or D are weak. The lower the rating, the higher the risk and the chance of default. Bonds rated BBB- or higher (up to AAA) are considered strong and investment-grade bonds.
What is the default yield on corporate bonds?
The default yield on corporate bonds is the maximum amount promised that the issuer of the corporate bond agrees to pay the bondholder if the bond defaults. The issuer agrees to this maximum payment amount because corporate bonds often come with a higher default risk, and investors want to ensure that they are compensated well for taking on that risk.
Source: https://www.thebalancemoney.com/bond-default-definition-and-explanation-416900
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