Download the Schwab app from iTunes®Get the AppClose

Corporate Defaults: What Investors Should Know When A Bond Issuer Goes Bankrupt

Key Points
  • The U.S. corporate default rate continues to climb and is now at a more than 6-year high

  • After a default, what a bondholder receives, and when they receive it, is unknown in advance

  • An investor may attempt to sell a defaulted bond in the secondary market or hold it through the bankruptcy process, but the proceeds would likely be far less than the bond’s original value

With the U.S. corporate default rate at a more than 6-year high, a growing number of investors may be wondering what they should do if their bond issuer is unable to repay its debts. 

Unfortunately, the answer isn’t always straightforward. There are, however, several things corporate bond investors should know.

Reasons leading to a default may differ and can affect the restructuring and repayment process. What bond holders receive after the default—and when they receive it—can vary significantly. And any recovery proceeds may come in different forms, including as a newly issued bond, and the process can take anywhere from a few months to several years. Below we’ll discuss what investors need to know when their corporate bond defaults.

Defaults have been on the rise

Since bottoming at 1.4% in July 2014, the trailing 12-month speculative-grade default rate rose to 5.1% in December 2016.1 However, much of the rise is due to issuers in the energy and natural resource sectors, as the sharp drop in commodity prices over the past few years has weighed on their cash flows. The default rate for energy and natural resource issuers hit 27% in December, the highest reading ever for those two sectors combined. Excluding commodity-related bonds, the default rate has only risen modestly to 2.4% over the past few years and is still below the long-term average of 4.3%.

With the default rate still rising, the risk of holding an individual bond that defaults is still high, so investors need to be aware of what a bond default means for bondholders.

The default rate keeps rising

Source: Standard and Poor’s Trailing 12-Month Speculative-Grade Corporate Default Rate, December 2016. S&P conducts its default studies on the basis of groupings called static pools. For the purpose of the study, S&P forms static pools by grouping issuers by rating category at the beginning of each year that the CreditPro database covers. Each static pool is followed from that point forward. All companies included in the study are assigned to one or more static pools. When an issuer defaults, S&P assigns that default all the way back to all of the static pools to which the issuer belonged. S&P calculates annual default rates for each static pool, first in units and later as percentages with respect to the number of issuers in each rating category.

The basics of a default

What do we mean by “default”? Credit rating agencies define default a few ways, but for many individual investors, what matters is when a company files for bankruptcy protection. Issuers under financial stress, such as those facing liquidity or solvency concerns, may consider Chapter 7 or Chapter 11 bankruptcy protection. What investors get after the bankruptcy process can vary considerably.

A company that files Chapter 11 bankruptcy receives protection from creditors and time to restructure its obligations. Once the bankruptcy process is completed and the restructuring plans are approved in court, the corporation “emerges” as a newly organized and restructured company. The restructured corporation is usually in better financial shape, with less debt than before the bankruptcy proceedings. Depending on the size and complexity of the bankruptcy, this process can take a few months to several years.

Chapter 7 is more of a “last resort” option. Rather than restructuring, a Chapter 7 bankruptcy means the corporation ceases operations and liquidates its assets. As the corporation sells its assets—sometimes at very depressed prices—the proceeds are used to pay off its creditors, which includes bondholders. Like a Chapter 11 bankruptcy, it can take a long time for bondholders to receive any proceeds from a Chapter 7 filing. The order of payment can vary. Corporate bond holders are often below government taxes, bank loans and other creditors like employees and suppliers. But they are ahead of preferred and common stockholders.

There are other ways that bonds can “default,” according to credit rating agencies like Moody’s and Standard and Poor’s. If a corporation breaks one of its covenants, that can trigger a default.2 The rating agencies also consider a “distressed debt exchange” a default.3 These types of defaults may not have a significant impact on individual bond investors since they may not need to go through court proceedings, and individual investors are usually excluded from distressed debt exchanges.

What happens to holders of corporate bonds that default?

Unfortunately, what happens to bondholders after a default isn’t always easy to answer. As discussed above, bankruptcy processes can take a long time. More often than not, however, bonds of issuers facing financial difficulties will drop in price as investors become concerned with the issuer’s ability to make timely interest and principal payments. A drop in price doesn’t always lead to a default, however, and prices could rebound.

When a firm does file for Chapter 7 or Chapter 11, what bondholders “recover” can vary significantly. Recovery is what a bondholder ultimately receives from holding a defaulted bond. Unfortunately, both the ultimate recovery value and how long it will take to actually receive the recovery value are unknown in advance. Most importantly, the recovery is often less than the $1,000 par value of the bond. In other words, it’s unlikely that an investor would “recover” what the bond was originally worth.

It’s not just the value of the proceeds that can vary, but how investors are compensated. It’s usually not as simple as just receiving a cash payment in lieu of the defaulted bonds. Since Chapter 11 results in a newly organized company, holders of the defaulted bonds usually receive some sort of new securities as proceeds.  The proceeds may consist of new bonds, an equity stake in the company, equity warrants, or some combination of those options.3 In a Chapter 7 bankruptcy, bondholders often receive cash proceeds as the issuer liquidates its assets. The proceeds may come in installments, as various assets are liquidated, and this can take a very long time. For both types of bankruptcies, recovery is often well below the defaulted bond’s $1,000 par value.

This chart illustrates that what bondholders eventually receive can vary and is often well below the amount that many investors may have initially invested. “Ultimate recovery” is the value that creditors realize at the resolution of the default event. In other words, it’s the value of the proceeds if the defaulted bond is held through all of the court proceedings.

Ultimate recovery values often tend to be well below initial par values

Source: Moody’s Investors Services. “Annual Default Study: Corporate Default and Recovery Rates, 1920-2015,” February 29, 2016. Ultimate recovery is the value creditors realize at the resolution of the default event. For example, for issuers filing for bankruptcy, the ultimate recovery is the present value of the cash and/or securities that the creditors actually receive when the issuer exits bankruptcy, typically 1-2 years following the initial default date.

Key points to be aware of when a corporate bond you own defaults:

  • The time until ultimate recovery is unknown. Some restructurings are done relatively quickly, while the restructuring process for more complex issuers could take several years.
  • The defaulted bond won’t act like a bond anymore. Bonds are often purchased for the income payments they provide. Since defaulted bonds no longer make coupon payments, investors are stuck holding non-interest bearing investments with an unknown recovery value and unknown recovery date.
  • Credit ratings can be important. If a bond has been downgraded, its likelihood of default may have risen. Consider the outlook for the issuer, and consider selling the bond in the secondary market if the issuer’s financial condition worsens. Note that the market for lower-rated issues is less liquid, and sometimes considerably less liquid, than more conservative, high quality fixed income investments.
  • The bankruptcy process can be time consuming. Investors will likely need to deal with legal paperwork and may need to vote on certain provisions related to the court proceedings. If this may seem too complex and burdensome, investors may want to consider selling their bonds—likely at a lower price—in the secondary market.

The bottom line

Unfortunately, dealing with a defaulted bond isn’t very straightforward. But investors do have a couple of options:

  1. Continue to hold the defaulted bond through the bankruptcy proceedings. But how much bondholders receive, and when they receive it, is unknown in advance.
  2. Sell the bond in the secondary market. You’ll get a known amount and won’t need to be concerned with the bankruptcy proceedings. Selling a defaulted bond before the restructuring process is over can lead to more or less than what may have been received if the bond was held through the restructuring process.

What You Can Do Next

3 Strategies for Lowering Taxes in Retirement
Five Reasons to Stay Invested Despite Heightened Uncertainty
Five Reasons to Stay Invested Despite Heightened Uncertainty

Important Disclosures


Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.