Bonds are backed by the financial strength of the bond issuer.
If the bond issuer is not able or chooses not to pay, a bond can be in default. The reasons for default can vary from an inability to pay, to a desire to reduce the actual bond’s obligation. While US Treasury securities never default, corporate bonds default on a regular basis.
So what happens to a bondholder when a default occurs? Let’s talk about bankruptcy first. Bond issuers have two workable options within the bankruptcy system.
Chapter 7 and Chapter 11.
Chapter 7 means the company ceases operations and closes its business. The bankruptcy court will review options, possibly a reorganization can be put in place. Generally, when a company files for Chapter 7 Bankruptcy, it has already worked all possible options. The court will appoint a trustee and liquidate assets and attempt to pay outstanding claims.
Claims are based on a pre-set order, secured creditors and any senior debt holders, bondholders are second, and stockholders of the company are last. If you are a bondholder, there is no defined time in which you will receive a payment. That decision is up to the court. Often bondholders can receive all that is owed to them, a partial share, or nothing at all. Occasionally a payment system is set up for bondholders and funds could be received from the sale of assets over time.
Chapter 11 Bankruptcy is a different situation. A company filing for Chapter 11 protection will attempt to reorganize and re-establish its business model, often times with debt relief. Chapter 11 shields the company from creditors and allows the courts to help establish a system in which the company can work out the debt issues.
Bondholders are usually asked for restructuring, which could mean a loss of value or a change in earned interest. Once the reorganization plan has been agreed upon by the company and the Court, notification is made to creditors and bondholders. Bondholders and creditors may be issued a combination of stock and new bonds in the restructured corporation in exchange for their bonds.