Glossary
Default
A borrower's failure to make a required interest or principal payment, or to meet other terms of a loan or bond.
A default occurs when a borrower breaks the terms of its debt. The most serious kind is a payment default: missing an interest or Principal payment after any grace period has passed. A technical default is a breach of other promises in the loan or bond agreement, called covenants, such as keeping debt below a set multiple of earnings, even while payments continue.
What happens next
When a company defaults, its lenders and bondholders gain the right to demand faster repayment, and several outcomes are possible:
- Waiver or amendment. For technical defaults, lenders often agree to new terms in exchange for a fee or a higher rate.
- Distressed exchange. Bondholders swap their bonds for new ones with lower face value or later maturity. Ratings agencies usually treat this as a default.
- Bankruptcy. In the US, Chapter 11 lets the company keep operating while it reorganizes its debts; Chapter 7 liquidates it.
Claims are paid in order of seniority: secured lenders first, then unsecured bondholders, then preferred and finally common shareholders, who often receive nothing.
Why it matters to investors
Credit Risk is, at bottom, the probability of default times the loss if it happens. Default rates on high-yield bonds rise sharply in recessions, while defaults by highly rated Investment grade companies are rare in any single year. Bond prices usually fall well before a default as the Credit Spread widens, so markets often price the risk long before the missed payment. Governments can default too, though the US Treasury has never missed a payment on its marketable debt for inability to pay.