What Happens When Your Bond or Sukuk has Defaulted?

Bond-Default-(Banner).jpg
 

Introduction

When the performance of market created worries among investors, they typically shift their investments from higher risk financial instruments like stocks, to safer fixed-income assets such as bonds. But does bond ensure a safe investment route to the investors? Like any other investments, bonds and sukuk carry risks too and one of them is turning to default. (Sukuk refers to Islamic bond. Read more here)

If an individual fails to make his monthly mortgage payments, he defaults on the loan. Similarly, if a business issues bonds and it is unable to make payments to its bondholders, the business is in default on its bonds. When deciding whether to issue a loan or invest in a debt security, lenders and investors must carefully consider the chance of default and must manage its risk.

What is bond default?

Default is the failure to pay interest or principal on a loan or security when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment, and it also refers to cases in which one party fails to perform on a futures contract as required by an exchange.

When a company issues bonds, it's obligated to make regular interest payments to bondholders and repay their principal investments once the bonds come due. Whenever a company fails to uphold its obligations to bondholders, whether it's in the form of a missed interest payment or a missed principal payment, it's considered a bond default.

When bond defaults become a reality, bond investors are more likely to lose some, if not all of the capital invested in the debt. Therefore, it is paramount for bond investors to be able to claim or recover its capital within the terms and conditions of the bonds as stipulated in the Trust Deed. 

A Trust Deed is an agreement between bond issuer and bondholders covering terms of bond issuance. The bond terms normally include both positive and negative covenants, event of default, identification of the collateral, call provisions and appointment of trustee.

Why does bond go into default?

The main reason being its deteriorating financial health, thus its ability to service the interest and repay the debt is in serious doubt. Usually default happened when the company’s cashflow is severely affected up to the point where the company is not able to generate income to repay its debt obligations.

The biggest private default in history is Lehman Brothers, with over USD600 billion when it filed for bankruptcy in 2008. The biggest sovereign default is Greece, with USD138 billion in March 2012.

Some of the factors affecting the cashflow include business environment, overestimation of projected income, mismanagement (fraud & breach of trust), political intervention, regulatory changes and overextending balance sheet (excessive borrowings).

Multiple countries have excellent records of paying on sovereign debt obligations and have never defaulted. These nations include Canada, Denmark, Belgium, Finland, Malaysia, Mauritius, New Zealand, Norway, Singapore, Switzerland and England.

What happens when bond default?

  1. Debt restructuring
     
    • When an issuer faces financial distress, it may decide to restructure its debt. It is a process that allows a private or public company, or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.
       
    • Some ways the issuer could conduct debt restructuring include:
       
      • Reducing the amount owed such that the investor will be paid less than what was originally promised AND/OR
         
      • Extending the tenure of the bonds such that the issuer can repay the principal at a later date in order to improve the firm’s chances of paying back its loan.
         
    • In addition to the reduction of the total loan amount owed or an extension of the period of repayment, a debt restructure could also include a debt-for-equity swap. What is debt-for-equity swap? It is a process of exchanging the debt for equity such that the investor will receive shares in the issuer in exchange for the bond and will no longer be entitled to the principal or the coupons.
       
    • If a financially distressed issuer is unable to restructure its debt, it may run into problems fulfilling the payment obligations under the bonds and could eventually default on the bonds. When an issuer is unable to pay its debts, it may eventually be wound up.
       
  2. Winding up
     
    • Winding up or liquidation is the method of ending, or dissolving, a business. The winding up activity includes selling all assets, paying off creditors, and distributing remaining assets to the creditors (including bondholders) ahead of shareholders. Winding up can refer to dissolving either a corporation or a partnership.
       
    • Winding up a business is a legal process regulated by corporate laws as well as a company's articles of association or a partnership agreement. Winding up can be compulsory or voluntary and can apply to both publicly and privately held companies.
       
    • Compulsory winding up happens when laws, or court orders, force a company to appoint a liquidator who sells assets and distributes the proceeds to creditors. A company’s creditors will often trigger the process. In time, creditors will realize that a company is insolvent due to unpaid bills. Winding up, or liquidation, is sometimes part of a bankruptcy proceeding. In some cases, a company may not have sufficient assets to satisfy all its debtors entirely, and then these creditors will face an economic loss.
       
    • Shareholders or partners may trigger a voluntary winding up. Voluntary liquidation is usually brought on through a resolution. The company may or may not be insolvent. If solvent, the reason for winding up may be that the shareholders feel their objectives were met and that it is time to cease operations and distribute company assets.
       
  3. Judicial management
     
    • An alternative to winding up is for the company or its creditors to apply to the Court to put the issuer under judicial management.
      In general, when a company is under judicial management, the company is protected from claims by creditors. Bondholders are unlikely to receive their coupons or principal payments on their bonds.
       
    • During this period, the judicial manager takes on the role of the company’s board of directors and runs the business with the aim of its survival or to realise the assets for the benefit of creditors without liquidating the company.
       
    • The judicial manager will provide creditors with a statement of proposals (e.g. a proposal for achieving the survival of the company), and the creditors will decide at a meeting of creditors whether to approve the judicial manager’s proposals.

Mitigating the defaults

While the country is developing its bond market, it seems like the local market is still lacking instruments or products which may help mitigate the default risk. However, there are five ways of how an investor in Malaysia can mitigate the defaults.
  1. Macro factors analysis
    Investors can put up their own initiatives by doing analysis which should cover the macro factors affecting the issuer i.e. industry, economic environment, geopolitical conditions, etc. 

    The constant monitor may provide an early signal to the bond investors on the financial state of the issuer and will give bond investors an inkling on its next step of actions.
     
  2. Credit analysis
    Credit analysis by rating agencies could be used as an independent credit views or a second opinion whilst the decision on the credit should eventually still lie with the investors.
     
  3. Monitor bond using BIX Malaysia’s tools
    Bond and Sukuk Information Exchange (BIX) is a platform established to provide free public access to information on bonds and sukuk issued in Malaysia. It is created to support SC’s liberalisation in creating a platform for investors to educate themselves regarding the matters related to bond and sukuk.
     
  4. Know your right as bond investor
    One of the ways investors can protect their right is to do a thorough study on bond and sukuk covenant.

    A bond covenant is a legally binding term of agreement between a bond issuer and a bondholder or investor. The covenant main function is to protect the interest of both the bond holder and issuer. The bond or sukuk Principal Term & Condition (PTC)  and Information Memorandum (IM) document will have the detail on the covenant and issuer’s information
    • Investors can look up any company’s PTC through BIX’s website by using BIX Tools. For more information on bond and sukuk covenant and the importance as well as graphic tutorials, refer to BIX Article here.
       
  5. Who to call when your right has been breached?
     
    • Bond Trustee
       
      • In Malaysia for example, institution such as AmanahRaya Trustees Berhad sees that bond interest payments and principal repayments are made as scheduled and protects the interests of the bondholders if the issuer defaults.
         
    • Authority and regulatory body
       
      • Securities Commission Malaysia (SC) could play its roles in ensuring that the restructuring or the recovery process are conducted within the regulations and laws is there to ensure the issuers of these securities as well as the rating agencies to follow the correct regulations to avoid the violation of investors’ rights.

Conclusion

Individuals can avoid the impact of defaults by sticking with high-quality individual securities or lower-risk bond funds. Active managers can avoid default risk through intensive research, but keep in mind that a rising default can weigh on entire market segments and therefore 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 especially if a country goes into default.
 
Sometimes bond defaults resolve themselves. It can happen that an issuer experiences a temporary cash flow problem that causes it to miss a payment, but then makes that payment a week later. While this type of scenario technically constitutes a default, it is not harmful from a bondholder perspective. 

But while some bond defaults resolve themselves quickly, others signify major financial trouble for the issuer. In fact, it's often the case that a company that defaults on its bonds will file for bankruptcy shortly thereafter.

In Malaysia, bondholder rights are protected under the Companies Act 1965 and Securities Industry Act 1993. Under the Companies Act, creditors, including bondholders, can file a winding-up petition for a company when the debtor is unable to pay its debts. When a winding-up order is made, the court appoints a liquidator who oversees the liquidation process.

Bondholders can lodge complaints if they feel their rights are violated. They can go to SC, The Capital Market Compensation Fund Corporation (CMC) and also Securities Industry Dispute Resolution Center (SIDREC). 

Foreign creditors have the same rights as local creditors under Malaysian laws. Under the Securities Industry Act (SIA), all bond issuers are required to enter into a trust deed with an appointed trustee. The trust deed contains bond provisions, covenants, and other requirements set by the Securities Commission (SC). The trustee's role is to safeguard the interests of the bondholders as set out in the trust deed and in the SIA. For more information on bond and sukuk covenant and the importance, refer to BIX Article here.

Bond documents (e.g., prospectus, term sheets) also contain covenants and relevant default clauses specific to the bond issue that provide additional protection to bondholders. The Security Commission's site provides copies of term sheets and/or principal terms and conditions of bond issuances. 

Disclaimer
This report has been prepared and issued by Bond and Sukuk Information Platform Sdn Bhd (“the Company”). The information provided in this report is of a general nature and has been prepared for information purposes only. It is not intended to constitute research or as advice for any investor. The information in this report is not and should not be construed or considered as an offer, recommendation or solicitation for investments. Investors are advised to make their own independent evaluation of the information contained in this report, consider their own individual investment objectives, financial situation and particular needs and should seek appropriate personalised financial advice from a qualified professional to suit individual circumstances and risk profile.
 
The information contained in this report is prepared from data believed to be correct and reliable at the time of issuance of this report. While every effort is made to ensure the information is up-to-date and correct, the Company does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information contained in this report and accordingly, neither the Company nor any of its affiliates nor its related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.

 
Stay on top of what’s happening in bond and sukuk markets.
Enter security code:
 Security code
 

Sign up to receive update on BIX Malaysia articles and tutorials or you can Read Our Last Edition »