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.
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 by downgrades to the credit ratings of 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-rated corporate bonds defaulted 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 include U.S. Treasury’s mortgage-backed securities backed 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 high credit 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 are high-yield bonds and 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-risk bond funds. Active managers can 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.
