When investing in corporate bonds, it's essential to consider default risk, the risk that a company will fail to make timely interest or principle payments.
But what exactly does it mean when a bond is in default? To better understand this, let's start by examining the types of default events that can occur.
In general, a default event refers to any breach of the contractual agreements between the issuer and bond holders.
These events are crucial for investors as they can signal increased financial strain on the issuer and may affect the bond's value or the issuer's credit rating.
In practice, we distinguish between two main types of default events.
The first is known as a technical default, which occurs when the issuer breaches non-monetary terms such as violating a covenant.
For example, if the issuer fails to maintain a required financial ratio, this would be considered a technical default.
These events are often resolved through negotiations with bond holders rather than through drastic actions.
The second type is a payment default, which happens when the issuer fails to make a required interest or principle payment.
If an issuer misses a payment and does not resolve it within a grace period, typically defined in the bond terms, the bond is declared in default.
But what happens after a payment default? Once a payment default occurs, the issuer and lenders typically need to explore options for restructuring to address the missed payment and stabilize the issuer's finances.
There are two main pathways for restructuring.
The first is consensual restructuring.
This is an out of court process where all lenders agree to a plan to help the issuer manage its obligations.
The restructuring plan might include measures like lowering interest rates, reducing the debt amount, or extending the maturity of the bond. Out of court restructuring is generally quicker and more flexible as it does not require court approval.
However, consensual restructuring often fails due to a collective action problem with multiple bond holders, each with different interests and priorities.
It can be challenging to reach unanimous agreement on restructuring terms.
This lack of alignment can make it difficult to achieve a cohesive restructuring plan.
If consensual restructuring isn't feasible, the issuer might enter bankruptcy.
A formal legal process.
For example, in the US there are two main bankruptcy options.
The first known as Chapter 11, allows the business to restructure and continue operating as a going concern.
The company reorganizes its debt to create a sustainable path forward.
The second option is Chapter 7.
This involves the liquidation of the company's assets.
Effectively ending the business. Assets are sold, and bond holders may receive a portion of the liquidation proceeds depending on their priority in the capital structure.
Secured creditors are paid first from specific collateral followed by unsecured creditors.
And lastly, equity holders.
Chapter 7 often results in lower recovery rates for bond holders due to the costs and the process of asset liquidation.
It's worth noting that these bankruptcy processes refer specifically to US law.
Other countries have similar procedures, although the specific legal frameworks differ.
