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Default

An issuer's failure to meet its obligations, most commonly a missed interest or principal payment or a bankruptcy filing, which ends normal coupon payments and starts a recovery process.

Default is a process rather than an instant. It usually begins with a missed payment and a grace period, moves into negotiation or bankruptcy, and ends months or years later with creditors receiving cash, new debt, equity, or some mixture.

Bonds stop trading on yield and start trading on price once default is likely, because the cash flow schedule is no longer meaningful. Price then converges on the expected recovery-rate, and the bond trades flat, meaning without accrued-interest.

Example: the trailing twelve-month high yield default rate is 3.2% by issuer count. With a 40% average recovery, an investor holding the whole index loses roughly 3.2% x 0.60 = 1.9% of principal over that year.

Related: recovery-rate, credit-event, high-yield, probability-of-default, distressed-debt

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

An equity curve and its drawdownAn account balance rising over a year, falling from a peak to a trough, then climbing back to the old peak.ACCOUNT EQUITY$20k$12k$8k024681012TIME (MONTHS)PEAK $16,000TROUGH $12,000DRAWDOWN−25%RECOVERY
Equity curve and drawdown. An account balance plotted month by month. The fall from the $16,000 peak to the $12,000 trough is a 25% drawdown, and the shaded area lasts until the balance climbs back to the old peak.

Educational only, not advice. Spotted an error? Post in Site Feedback.