Default Risk

Study Notes:

A corporate bond is essentially a contract made between an issuing company and an investor, who, unlike a shareholder of a stock, becomes a creditor of that company – not an equity owner.

The basic structure of the contract typically requires that the firm pay the investor all interest payments due over the time the bond is held, as well as the bond’s par value when it matures. If the issuer fails in any way to satisfy this debt service, it will be said to be in default.

For example:

If an issuer sells a ten-year corporate bond with a par value of $1,000 at a fixed, annual  interest rate, or coupon, of 2.5%, then the investor under these terms must be paid $12.50 every six months over the ten year period, as well as receive the initial $1,000 investment when the bond retires. If any of these payments are missed, the issuer will be in default.   

What happens if a company goes into default or files for bankruptcy?

As a creditor of the company, a corporate bond holder owns a claim on the issuing firm’s assets and cash flows. However, the terms of the bond held will dictate the priority on that claim, and these are based, for example, on whether the bond is secured – meaning the issuer may have pledged certain collateral such as property, equipment, or other assets that it owns as security — or if it is unsecured.

Priority claims are generally addressed in the following order:

• First, holders of senior secured bonds are paid, then
• Those holding senior unsecured bonds, then
• Senior subordinated notes, then
• Junior subordinated notes, then
• Convertible bonds, then
• Preferred stocks, then
• Holders of ordinary stocks.

Holders of corporate bonds are also not the company’s only creditors, considering that it may also have obligations it owes to banks, its customers and suppliers, as well as employees, pensioners, and others, with some possibly competing on the same, or higher priority level, as certain bond holders. Typically, these claims are resolved through the bankruptcy court.

Since it is this default risk that a corporate bond investor is typically most concerned with, it is important to conduct a deep analysis of the financial health, creditworthiness, and overall operational strength of the issuing company, as well as the internal and external risks it faces.

Before investing in a corporate bond, an investor may ask, for example:

• What is the company going to use the proceeds from this bond sale for, and will it significantly alter its credit profile?
  • Is it to finance an acquisition, repurchase stock, or pay down existing debt at a lower interest rate?
• Has the company been profitable?
• Does it have healthy free cash flow?
• How well has it been managing its existing leverage?
• Where does the bond fall in terms of the company’s priority of payments in the event of bankruptcy?
  • Is it secured or guaranteed?
• Will U.S. interest rates make future financing or refinancing more difficult for the firm?

Other considerations include:

• The stability, effectiveness and reputation of the company’s management,
• Whether it faces any significant fallout from unresolved legal actions, and
• Whether any adverse economic or political conditions pose a material impact on the firm, or the sector, in which it operates.

A corporate bond investor may also appeal to the analysis conducted by a nationally recognized statistical rating organization (NRSRO) such as Moody’s Investors Service or S&P Global Ratings, which are SEC-approved credit ratings agencies.

While we’ll discuss these credit ratings in more depth in a later lesson, it is important to keep in mind that a firm’s credit rating may change over time, depending on the credit conditions of the issuer.