Investing Assets & Markets Bonds What Is a Bond Default? By Thomas Kenny Updated on October 24, 2022 Reviewed by JeFreda R. Brown Reviewed by JeFreda R. Brown Facebook Instagram Twitter JeFreda R. Brown is a financial consultant, Certified Financial Education Instructor, and researcher who has assisted thousands of clients over a more than two-decade career. She is the CEO of Xaris Financial Enterprises and a course facilitator for Cornell University. learn about our financial review board Fact checked by Hilarey Gould In This Article View All In This Article How Does a Bond Default Work? Bond Defaults and Market Performance Market Segments With High Defaults What It Means for Investors Frequently Asked Questions (FAQs) Photo: d3sign / Getty Images Definition A bond default occurs when the issuer of the bond fails to make interest or principal payments within the specified period. A bond issuer may default when it has run out of cash to pay bondholders. Bond default is usually a sign of financial distress, and a last resort. Key Takeaways A bond default occurs when a bond issuer fails to make payments within the specified period.A bond default doesn’t always mean you’ll lose all of your principal; you’ll most often receive a portion of it back.Highly rated bonds tend not to default. Be sure you check bond ratings before you buy. How Does a Bond Default Work? In the case of corporations, bond defaults usually occur when deteriorating conditions lead to a decline in revenues, making scheduled repayments impossible. Countries are often forced to default when their tax revenues are no longer enough to cover their debt servicing costs and ongoing expenses. 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. Note When a bond defaults, it doesn’t just go away. The bonds often keep trading at sharply reduced prices. They sometimes attract “distressed debt” investors who think they can recover more from the dispersal of the company’s assets than the price of the bond reflects. 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. Frequently Asked Questions (FAQs) Which bond rating does Standard & Poor's assign to a bond that is in default? Standard & Poor's has 22 bond ratings. The bonds with a rating of CC to BB+ are considered non-investment grade bonds. Bonds with a C or D rating are seen as weak. The lower the rating, the more risk and chance of a bond default. Bonds rated BBB- or higher (up to AAA) are considered strong and investment-grade bonds. What is the default risk premium on corporate bonds? The default risk premium on corporate bonds is the higher promised payment that a corporate bond issuer agrees to pay a bondholder if it defaults. Bond issuers agree to this higher payment because corporate bonds often come with a higher risk of default, and investors want to be sure they'll be paid well after assuming the risk. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Moody's Investors Service. "US Municipal Bond Defaults and Recoveries, 1970-2021," Page 8. Fidelity. "Bond Ratings." SEC Office of Investor Education and Advocacy. "What Are Corporate Bonds?"