Question

7. What happens when a company defaults on paying a bond

Answer 1

(Q) What happens when a company defaults on paying a bond ?

(Ans) In its simplest form, a default means when an issuer fails to make a scheduled interest or principal payments on its bonds. According to credit rating agencies like Moody’s and Standard and Poor’s, if a corporation breaks one of its covenants, that can also trigger a default. Defaults can have consequences such as lower of the credit scores, reduced chances of obtaining credit in the future, and higher interest rates on existing debt as well as any new obligations. Unlike treasury securities which are considered risk free because they are backed by the full faith and credit of the US federal government, corporate bonds default on a regular basis. When a company defaults, the government is under no obligation and is unlikely to rescue the company. 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.

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. Typically, companies file for bankruptcy protection prior to a bond default. If a company defaults without declaring bankruptcy first, then creditors are likely to force them into bankruptcy.   US companies can file for bankruptcy either under Chapter 7 or Chapter 11. 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.