When a corporation or municipality issues a bond, they are borrowing money from investors. In exchange for the funds, the bond issuer promises to pay the bond buyers a specified rate interest during the life of the bond, and to repay the principal when it matures. If a company defaults on these payments, there are ways investors can attempt to recover their money, but more likely than not they will not be able to recoup the entire investment.
Moody's Investors Service, which researches the credit quality of bond issuers and assigns a credit risk rating to their bonds, defines a bond default as "any missed or delayed disbursement of interest and/or principal." Default also includes bankruptcy, receivership, or instances where the bond issuer gives bondholders replacement securities of a lower interest rate, longer term to maturity or inferior rights to collect in the event of liquidation of the company's assets.
When a company or municipality enters financial crisis, it has two choices: liquidation or work out. Unless the prospects are hopeless, the company, its creditors and shareholders work with the federal bankruptcy court to negotiate more lenient payments to creditors. This is done in the hope of successfully reorganizing the company and returning it to profitability. Bondholders have first rights to the assets of the company, right behind the bank.
Types of Bonds
First mortgage bonds are collateralized by certain assets, such as facilities built with the proceeds of the bond issue. Second mortgage bonds have subordinated rights to the liquidation value of the stipulated assets. Debentures are general obligations, without specified collateral. Senior debentures have rights before debentures and subordinated debentures have the least rights to proceeds of liquidation. Theoretically, the bondholders with the most senior bonds must be paid interest and principal in full before other bondholders, but that depends on the decision of the court overseeing the reorganization or liquidation.
A Federal Reserve Board study of bondholders' rates of recovery of money owed when their bonds defaulted, showed that during the period of the 1980s and 1990s, bondholders recovered an average of only 40 percent of what they were owed, with actual recovery rates ranging from a low of approximately 25 percent to a high of approximately 65 percent. There are various reasons for these rates of recovery, but they are based on two standard bondholder actions -- either selling the bonds into the market at the first sign of default, or waiting through bankruptcy proceedings for the court-mandated settlement.
These studies show that in the event of default, you are unlikely to receive the full payment of interest and principal to which you are entitled. However, some bonds go through temporary periods of non-payment of interest, making them technically in default, but resume interest payments and pay principal in full after their financial crisis has passed. The higher the credit quality of the company, the better your chance of experiencing a positive outcome. Your financial adviser should be able to give you guidance on the probable outcome for your bonds.
- Moody's InvestorsHistorical Default Rates of Corporate Bond Issuers, 1920-1999 Service;
- The Federal Reserve Board; An Empirical Analysis of Bond Recovery Rates -- Exploring a Structural Review of Default; Covitz and Han; December 2004
- PBS Newshour; What Happens to California State Bonds if the State Goes Bankrupt?; Paul Solman; June 2009
- Forbes; The Coming Bond Default Wave; Richard Lehman; September 2008
- Scott Olson/Getty Images News/Getty Images