What does it mean for bondholders when a company that issued their bonds becomes insolvent? The good news is that the US bankruptcy process offers them a variety of rights and protections that may increase the likelihood that they will recover the value of their investment. It's also good to remember that bankruptcy does not necessarily mean the end for a company or the securities it issues.
How bankruptcy works
Chapters 7 and 11 of the Federal bankruptcy laws govern how US companies go out of business or attempt to recover from financial distress.
When a company files for Chapter 7, it ceases operations and its assets are sold to repay creditors and investors.
Chapter 11 bankruptcy allows a company to reorganize in hopes that it may again become profitable. Once a restructuring plan is approved in court, the bankrupt corporation emerges as a newly organized company with less debt.
While either type of bankruptcy often means an investor loses money they had invested in the company's stock, investors holding bonds are more likely to recover at least part of the value of their initial investment.
Bankruptcy law sets clear rules for who gets repaid first. Courts rank creditors by priority, from those with the strongest claims to those with the weakest. This order determines both whether investors get paid and how much they may recover.
This hierarchy of repayment typically looks like this:
As the chart shows, senior debt holders (typically banks) get paid before all others. Bondholders are typically next in line—though their priority can vary depending on the type of bond—and a bankrupt firm may still have enough assets to repay at least part of what they are owed.
But while where you stand in line helps determine when and how much you get repaid for your investment, how you are repaid may vary depending on the company's business, the assets it has, and its path out of bankruptcy. Once a company files for bankruptcy, bondholders typically stop receiving principal and interest payments. When the process is complete, they may receive newly issued bonds, cash, or stock whose value may not equal the value of the bonds they owned.
In a Chapter 7 bankruptcy, bondholders receive cash from a sale of the company's assets, a process that may take years to complete.
Municipal bonds and bankruptcy
Bankruptcy risk isn’t limited to corporations. In rare cases, cities or other local governments can also run into financial distress and seek to restructure their debts.
Rules for municipal bankruptcy differ from corporate bankruptcy and vary by state, but the basic idea is similar: A court oversees a process to sort out claims and determine how creditors will be repaid.
Defaults in the municipal bond market have historically been uncommon. But when they do occur, outcomes can vary widely. Bondholders may recover part of their investment, though the amount—and the timing—depend on the issuer’s finances, the type of bonds involved, and the legal structure backing them.
As with corporate bonds, credit quality, revenue sources, and legal protections all play a role in determining risk.
What to do if faced with rising bankruptcy risk
A default or failure to pay interest to bondholders typically precedes bankruptcy, and a company will show signs of distress before defaulting. Credit rating downgrades, declining earnings, and other events can indicate problems. Bonds of issuers facing difficulties will also typically drop in price as markets become concerned with the issuer's ability to pay interest and principal. Investors should remember that the probability of downgrades and default increases according to how low a bond is rated, and higher-yielding bonds often have low credit ratings.
If you own a bond issued by a company or municipality at risk of default or bankruptcy, you face a choice between holding the defaulted bond through bankruptcy or selling it.
If you hang on, you face uncertainty over how much you will receive, and when you will receive it. If you sell, you'll know the amount you're getting. However, the amount you receive for selling before restructuring is complete can be less than both the amount you paid and also the amount you may receive if you hold on through the end of the bankruptcy.
Investing involves risk and research is an important part of managing risk. Fidelity's website tracks issuer events for corporate bonds and material events for municipal bonds, including downgrades and credit watches. Bondholders can also receive this information through email alerts, which provide opportunity to react to news of a downgrade or negative credit watch should they wish to.
Other useful resources include Fidelity's Yield Table on the bond research page, which can compare 120 yields at a time.
More information is available in the transition rate table, which shows the historical probability that a bond of a given credit rating will be upgraded or downgraded in a year's time. The lower the starting point in terms of credit quality, the higher the probability of further downgrades.
"We strive to provide investors with resources to research bonds and issuers before they invest," says Richard Carter, vice president of fixed income strategy at Fidelity. "It's important to know what you own and why, and to continue to monitor the bond and the credit standing of the issuer while you own it."