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If the bond issuer is not able or chooses not to pay, a bond can 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 regularly.
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. Generally, when a company files for Chapter 7 Bankruptcy, it has already worked all possible options. The bankruptcy court will review options; possibly, a reorganization can be implemented. The Court will appoint a trustee, liquidate assets, and pay outstanding claims.
Claims are based on a pre-set order, secured creditors and any senior debt holders, bondholders are second, and company stockholders are last. If you are a bondholder, there is no defined time to 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 with debt relief. Chapter 11 shields the company from creditors and allows the courts to help establish a system to work out the debt issues.
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