Glossary · Bonds and rates
Default
A default is when a borrower fails to pay interest or repay a loan on time as promised. For bondholders it usually means getting back only part of their money.
Also called: debt default, bond default, sovereign default, missed payment
In plain words
You lend a friend $100 and they promise to pay you back on Friday. Friday comes and they can’t. That is a default. For a bond, it means missing an interest payment or failing to repay the face value at maturity, even by a few days beyond any grace period.
After a default, bondholders rarely lose everything. A company may go through bankruptcy, sell assets or hand its shares to its lenders; a country usually negotiates to swap old bonds for new ones worth less. What lenders get back, as a share of what they were owed, is the recovery rate.
Default risk is why lenders charge risky borrowers more. The extra yield is the credit spread, and the agencies’ credit ratings try to grade the risk in advance.
Example
What a default can cost
- You hold $10,000 of a company’s bonds paying 6%: $600 a year.
- After two yearly payments the company misses the third and files for bankruptcy.
- Two years later the court’s plan gives bondholders 40 cents per dollar owed: $4,000.
- In all you got back $1,200 + $4,000 = $5,200 for the $10,000 you lent.
Recovery rates vary widely: secured lenders, first in line, usually get back much more than holders of unsecured or junior bonds.
One level deeper
Lenders are paid in order of seniority. Secured creditors, backed by specific assets, come first; then senior unsecured bondholders; then junior (subordinated) ones. Shareholders are last and often get nothing. That ladder is why two bonds of the same company can have very different yields.
Countries default too, but no court can seize a country, so it negotiates with its lenders. Argentina has defaulted on its foreign debt several times, including in 2001 and 2020; Greece’s debt restructuring of 2012 was the largest in history. Governments that borrow in their own currency rarely need to default, since their central bank can create the money, at the risk of inflation.
A technical default, breaking a promise in the loan contract (such as a limit on debt) without missing a payment, is less serious and is often fixed by negotiation. A default on payments, by contrast, usually locks a borrower out of the bond market or makes borrowing much dearer for years.
Why it matters
Default risk is the reason company bonds pay more than government bonds; judging it is most of a bond investor’s work.
A wave of defaults can spread: banks and funds that lose money lend less, which can push other borrowers into trouble, as in 2008.
For a country, a default usually means years of high borrowing costs and a hit to its economy.
A common mistake
Myth: When a company defaults, its bondholders lose everything.
In fact: Usually they get back part of what they are owed, through bankruptcy or a deal. Shareholders are the ones most likely to be wiped out, because lenders are paid first.
Questions people ask
What happens to my bonds if the company defaults?
They stop paying interest and their price drops to what the market expects to recover. You can sell at that price or wait for the bankruptcy or restructuring, which can take months or years, and receive cash, new bonds or shares.
What is a sovereign default?
A government failing to pay its own bonds. There is no bankruptcy court for countries, so it negotiates with its lenders, usually swapping old bonds for new ones with a lower value or a longer maturity. Argentina, Greece and Russia (in 1998) are well-known examples.
How can you tell if a borrower might default?
Watch its credit rating and, more quickly, the yield on its bonds. When investors get worried, the bonds fall in price and their credit spread over government bonds widens.
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About the numbers
- This page explains a term. It is not investment advice.