Explanation of a Bond Default
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. 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 sufficient to cover the combination of their debt servicing costs and ongoing expenses. More often than not, however, this problem is solved by a “restructuring” – 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 his or her principal. In the case of corporate bonds, for instance, 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%, according to Peritus Asset Management’s April 2012 white paper, "The New Case for High Yield." It means 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. In fact, 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. The result is that most defaults occur among lower-rated bonds issued by entities that already have well-known problems.
The odds are against a default for a security rated AAA bond. 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 Aa-rated muni bonds did so. Also, from 1920 through 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. Instead, the majority of defaults occur among lower-rated securities.
The Market Segments That Defaults Are Most Likely to Occur
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. Bonds with high credit risk 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 or the percentage of bond issues within a given asset class that have defaulted in the prior twelve months. When the default rate is low or falling, it tends to be a 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 therefore 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.