A bond default occurs when the bond issuer fails to make an interest or principal payment within the specified period. Defaults typically occur when the bond issuer has run out of cash to pay its bondholders, and since defaulting on a bond severely restricts the issuer’s ability to acquire financing in the future, a default is usually a last resort—and therefore a sign of severe financial distress.
In the case of corporations, defaults usually occur when deteriorating business conditions have lead to a decline in revenues sufficient to make scheduled repayments impossible. Similarly, countries are typically forced to default when their tax revenues are no longer enough to cover the combination of their debt servicing costs and ongoing expenses. This problem is often solved by a restructuring, which is an agreement between the issuing country and its bondholders to change the terms of its debt, rather than an outright default.
What Happens When a Bond Defaults
A bond default doesn’t necessarily mean that the investor is going to lose all of their principal. In the case of corporate bonds, the bondholders usually receive a portion of their original principal once the issuer liquidates its assets and distributes the proceeds among its creditors. In the high-yield market, for instance, the average recovery rate from 1977-2011 was 42.05%, meaning that an investor who paid $100 for a high yield bond that defaulted would have, on average, received $42 back once the assets were distributed among creditors. While a loss, this situation doesn't represent a total loss.
When a bond defaults, it doesn’t disappear entirely. The bonds often continue to trade at sharply reduced prices, sometimes attracting “distressed debt” investors who believe they will be able to recover more from the dispersal of the company’s assets than the price of the bond currently reflects. This is a strategy generally employed only by sophisticated institutional investors.
Defaults and Market Performance
The vast majority of defaults are anticipated in financial markets, so a good deal of the negative price action associated with a default may occur before the actual announcement. The majority of defaults are preceded by downgrades to the credit ratings of the issuing entity, which results in most defaults occurring among lower-rated bonds issued by entities that already have well-known problems.
In the 42-year period through 2011, 100% of AAA-rated municipal bonds paid all of the expected interest and principal payments to investors, while 99.9% of AAA-rated muni bonds did so. From 1920–2009, only 0.9% of AAA-rated corporate bonds defaulted. From these numbers, we can see that highly-rated bonds tend not to default—a reflection of the strong financial condition typically associated with a high rating.
Market Segments With High Defaults
The risk of default is lowest for developed-market government bonds (such as U.S. Treasuries), mortgage-backed securities that are backed by the U.S. government, and bonds with the highest credit ratings. Bonds whose prices are more impacted by the possibility of default than by interest rate movements are said to have a high credit risk, and they tend to perform when their underlying financial strength is improving, but underperform when their finances weaken.
Entire asset classes can also have high credit risk. These tend to do well when the economy is strengthening and 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 twelve 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
Individuals 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 intensive research, but 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.