A bond default occurs when the bond issuer fails to make interest or principal payment within the specified period. Defaults most often occur when the bond issuer has run out of cash to pay its bondholders. Since a default severely restricts the issuer’s ability to acquire financing in the future, it is usually a last resort. It is a sign of severe financial distress.
In the case of corporations, defaults usually occur when deteriorating conditions lead to a decline in revenues, making scheduled repayments impossible. Countries are often forced to default when their tax revenues are no longer enough to cover their debt servicing costs and ongoing expenses.
This problem is often solved by a restructuring, which changes the terms of the debt. This agreement between the issuing country and its bondholders prevents an outright default.
- A bond default occurs when a bond issuer fails to make payments within the specified period.
- A bond default doesn’t always mean you’ll lose all of your principal; you’ll most often receive a portion of it back.
- Highly rated bonds tend not to default. Be sure you check bond ratings before you buy.
What Happens When a Bond Defaults?
A bond default doesn’t always mean that you're going to lose all of your principal. In the case of corporate bonds, you'll likely receive a portion of your principal back. This may occur after the issuer liquidates its assets and distributes the proceeds.
In the high-yield market, for instance, the average recovery rate from 1982 to 2008 was 41.34%. Let's say that you paid $100 for a high-yield bond that defaulted. In that case, you would have received, on average, $41 back once the assets were distributed among creditors. While it may be a loss, it's still far from a total loss.
When a bond defaults, it doesn’t just go away. The bonds often keep trading at sharply reduced prices. They sometimes attract “distressed debt” investors.
Distressed debt investors think they can recover more from the dispersal of the company’s assets than the price of the bond reflects. This strategy is often employed only by sophisticated institutional investors.
Defaults and Market Performance
Most defaults are anticipated in financial markets. This means a good deal of the negative price action that comes with a default may occur before the default is announced. Many defaults are preceded by downgrades to the credit ratings of the issuing entity. This results in most defaults occurring among lower-rated bonds issued by entities that already have well-known problems.
Between 1970 and 2019, 100% of AAA-rated municipal bonds paid all of the expected interest and principal payments to investors. When it comes to AA-rated muni bonds, 99.9% did so. Over the same length of time, only 0.08% of AAA-rated corporate bonds defaulted within a five-year period. From these numbers, we can see that highly rated bonds tend not to default. This reflects the strong financial condition that often comes with a high rating.
Market Segments With High Defaults
The risk of default is lowest for developed-market government bonds. These include U.S. Treasury's mortgage-backed securities backed by the U.S. government, and bonds with the highest credit ratings. Bonds with prices that are more impacted by the possibility of default than by interest rate movements are said to have a high credit risk. They tend to perform when their underlying financial strength is improving, but they underperform when their finances weaken.
Entire asset classes can also have high credit risk. These tend to do well when the economy is strengthening; they may underperform when it is slowing. Prime examples are high-yield bonds and lower-rated bonds in the investment-grade corporate and municipal segments.
The impact of default risk in these areas of the market is measured by the default rate within a given asset class that has defaulted in the prior 12 months. When the default rate is low or falling, it tends to be positive for the credit-sensitive segments of the market; when it is high and rising, these segments tend to lag.
The Bottom Line
You can avoid the impact of defaults by sticking with high-quality individual securities or lower-risk bond funds. Active managers can avoid default risk through research. Keep in mind that a rising default can weigh on entire market segments and pressure fund returns, even if the manager can avoid securities that default. As a result, defaults can affect all investors to some extent—even those who don’t hold individual bonds.