What Happens When Your Bond Issuer Goes Bankrupt or Defaults?

When you purchase a corporate or government-issued bond, you expect to reap the benefits of its steady coupon. Bond issuers default or become insolvent at a far lower rate than issuers of riskier investment products like equities. Interest rates are low on many government-issued bonds because these instruments are considered to be low-risk. Even many corporate bonds, which are evaluated by credit rating agencies according to a complicated sliding scale of risk, are less dangerous than equities.

However, bond issuers sometimes default or go bankrupt. Bond issuers most likely to become insolvent include municipal governments and private firms that suffer financial setbacks. Bonds with a high likelihood of default are known as "junk bonds." Their relatively high coupon rates, which can exceed 10 percent on an annualized basis, provide their holders with some measure of protection against the threat of worthlessness. Regardless, a bond default is a serious event that can produce significant financial losses for both parties.

If your bond's issuer goes bankrupt, you're entitled to restitution under the U.S. Bankruptcy Code. However, you're not guaranteed to receive funds: Depending upon the jurisdiction in which the bankruptcy is filed, you may not be "entered" into the proceedings as a creditor. Once you receive legal notice of the bankruptcy, you'll need to contact the court and ensure that you are included in the bankruptcy. If you are, you'll get back some or all of your investment after the issuer's other secured creditors have been satisfied.

Since bonds are typically subordinated to several other types of debt, there is a chance that there won't be sufficient funds left to compensate you in full. As such, you may be forced to take a partial loss on your bond. This is known as a "haircut" and can range from 10 percent to 80 percent of the bond's total value. Even if you're compensated in full for the bond's face value, you may not receive any outstanding coupon payments on it. Check the bond's fine print to determine whether you'll receive these additional payments.

If your issuer defaults on the bond without declaring bankruptcy or proves unable to compensate you for your loss during the bankruptcy process, you may still be able to recoup some of your losses. Contact your issuer or a major credit rating agency to determine whether the bond carries insurance designed to pay out in the event of a default.

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