Key Points

  • Corporate defaults are likely to pick up due to the economic impact of COVID-19.

  • After a default, what bondholders receive, 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 likely to rise, 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. Recovery proceeds may come in different forms, including as a newly issued bond, cash, stock, or some combination of the three, and the process can take anywhere from a few months to several years. Below we’ll discuss what investors need to know when a corporate bond they own defaults.

Defaults are likely to rise

Corporate defaults are likely to increase due to the economic impact of COVID-19 and its effects on corporate earnings. The plunge in the price of oil could lead to even more defaults in the energy sector.

After declining from its recent peak of 5.2% in December 2016, the trailing 12-month speculative-grade default rate has hovered between 2.1% and 3.4% for the two years ending February 2020.1 That rate is expected to jump by the end of this year. According to Standard & Poor’s, the baseline forecast for the default rate is 10% by December 2020.

Despite its low current reading, the default rate is expected to rise to 10% by December 2020

Source: Standard and Poor’s Trailing 12-Month Speculative-Grade Corporate Default Rate, February 2020. 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. Shaded bars represent recessions.

S&P believes the oil and gas sector will be hit especially hard, but the number of defaults is likely to be widespread. The rating agency believes the high-yield market is especially vulnerable to this economic shock, as the percentage of issuers with ratings of “B-” or below (which are very low credit ratings) is at an all-time high of just more than 30%.2

One factor that tends to lead issuers to default is a surge in borrowing costs. Outside of paying off debts with cash on hand, corporations tend to issue new bonds to refinance maturing bonds. If the cost of borrowing is simply too high, it might make sense for an issuer to default rather than refinance at rates that might significantly impact its cash flows. We’ve already seen that happen with many high-yield bond issuers. The chart below compares the default rate with the average “spread” of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index. A rise in defaults tends to follow a rise in spreads, and the average spread of the index is at its highest level since the 2008-2009 financial crisis.

A rise in credit spreads tends to be followed by a rising default rate

Source: Bloomberg and Standard & Poor’s. Bloomberg Barclays US Corporate High Yield Average OAS (LF98OAS Index) and Standard & Poor’s Trailing 12-Month Speculative-Grade Default Rate. Monthly data as of 3/31/2020 and 2/29/2020 for the high-yield spread and the default rate, respectively. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Shaded bars represent recessions.