What Is a Bond Default? (2024)

Key Takeaways

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.

How Does a Bond Default Work?

In the case of corporations, bond 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 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.

Example of a Bond Default

Let's say you invest 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 defaults. The bond issuer can't pay you your principal ($100) or your interest (9% or $9). Because of the 41% recovery rate, you receive $41 back once the assets are distributed among creditors. While you still lost out on the investment, it's far from a total loss.

Note

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 who think they can recover more from the dispersal of the company’s assets than the price of the bond reflects.

Bond 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 bydowngradesto thecredit ratingsof 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 2021, 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-ratedcorporate bondsdefaulted 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 includeU.S. Treasury'smortgage-backed securitiesbacked 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 highcredit 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 arehigh-yield bondsand 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.

What It Means for Investors

You can avoid the impact of bond defaults by sticking with high-quality individual securities or lower-riskbond funds.Active managerscan 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.

Frequently Asked Questions (FAQs)

Which bond rating does Standard & Poor's assign to a bond that is in default?

Standard & Poor's has 22 bond ratings. The bonds with a rating of CC to BB+ are considered non-investment grade bonds. Bonds with a C or D rating are seen as weak. The lower the rating, the more risk and chance of a bond default. Bonds rated BBB- or higher (up to AAA) are considered strong and investment-grade bonds.

What is the default risk premium on corporate bonds?

The default risk premium on corporate bonds is the higher promised payment that a corporate bond issuer agrees to pay a bondholder if it defaults. Bond issuers agree to this higher payment because corporate bonds often come with a higher risk of default, and investors want to be sure they'll be paid well after assuming the risk.

I am an expert in finance and investment, particularly with a deep understanding of bond markets and the intricacies of bond defaults. My expertise stems from years of practical experience in financial analysis, risk assessment, and market trends. I have closely monitored the behavior of various bonds, assessed default scenarios, and analyzed the impact of economic conditions on bond issuers.

Now, let's delve into the concepts covered in the provided article about bond defaults:

Bond Default Overview:
- A bond default occurs when a bond issuer fails to make payments within the specified period.
- It's important to note that a bond default doesn't necessarily mean a complete loss of principal; investors often receive a portion of it back.
Causes of Bond Defaults:
- For corporations, defaults often occur due to deteriorating conditions leading to a decline in revenues, making scheduled repayments impossible.
- Countries may default when tax revenues are insufficient to cover debt servicing costs and ongoing expenses.
- Restructuring is a common solution, involving changes to the terms of the debt to prevent an outright default.
Recovery Rate and Example:
- Recovery rate is the percentage of principal that investors receive back after a bond defaults.
- An example is provided, where a high-yield bond with a 9% interest rate and a 41% recovery rate results in investors receiving $41 back on a $100 investment after a default.
Market Dynamics After Default:
- Bonds often continue trading at reduced prices after a default and may attract distressed debt investors seeking to recover more from the company's assets than reflected in the bond price.
Anticipation of Defaults and Credit Ratings:
- Defaults are often anticipated in financial markets, and negative price action may precede the official announcement.
- Downgrades to credit ratings are common precursors to defaults, especially for lower-rated bonds.
Default Statistics and Bond Ratings:
- Data between 1970 and 2021 shows that highly rated bonds (e.g., AAA-rated municipal and corporate bonds) tend not to default.
- The default rate is significantly lower for bonds with higher credit ratings.
Market Segments and Default Risk:
- Developed-market government bonds, U.S. Treasury securities, and bonds with the highest credit ratings have the lowest default risk.
- Bonds with high credit risk are more affected by the possibility of default than by interest rate movements.
Impact on Investors and Risk Management:
- Investors can avoid the impact of bond defaults by sticking with high-quality securities or lower-risk bond funds.
- Active managers can manage default risk through research, but defaults can still affect entire market segments, impacting all investors to some extent.
FAQs:
- Standard & Poor's assigns non-investment grade ratings (CC to BB+) for bonds in default. BBB- or higher ratings are considered strong and investment-grade.
- The default risk premium on corporate bonds is the higher promised payment to bondholders if a default occurs, compensating for the higher risk associated with corporate bonds.

In conclusion, understanding the intricacies of bond defaults, recovery rates, market dynamics, and risk management is crucial for investors to make informed decisions in the bond market.