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What Happens When a Bond Issuer Defaults?

TRI 5.12.16

 

Lately, there has been a lot of talk about bond defaults. And it’s not just junk bonds that are

failing to come through—some municipal bonds have also recently defaulted. This is

troubling for the millions of people who turned to the relative safety of bonds after losing

money in the tumultuous market of 2008 and 2009.

Understanding Defaults

Default is the term used when a bond issuer doesn’t pay either an expected interest (or

coupon) payment or the principal upon maturity. It’s important to note this because it

means that a default doesn’t automatically equal lost principal.

Generally, defaults occur when the bond issuer simply doesn’t have enough cash to make

the anticipated payment. This could be due to a temporary cash flow problem or a more

significant loss of business or tax revenue.

Bond Defaults Due to Temporary Shortages

When a bond issuer defaults on an interest or final payment due to a temporary shortage of

funds, it’s possible that the bondholder will eventually get the payment that was missed.

Even if they don’t, however, the bond issuer might miss no future payments.

Bond Defaults Due to Bankruptcy

If the company issuing the bond files for Chapter 7 bankruptcy, then bondholders are

second in line to claim proceeds when company assets are liquidated. This doesn’t mean

they’ll get all or most of the lost value back, but they may get some. This can take some time

as not all assets are easy to liquidate.

When a company files for restructuring under Chapter 11 bankruptcy, then the bond debt

will likely be restructured, which could mean that a new bond is issued with lowered

coupon payments or par value. Depending on the company’s plan for restructuring, the

bonds may even be converted into stock.

If a bond issuer declares bankruptcy, a third option for bondholders is to sell the bond at a

discount to a buyer who’s willing to wait for asset liquidation and/or restructuring. While

the bondholder may net less doing this than they would if they waited, this can bring them

some necessary liquidity.

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