Bonds and Bond Derivatives, Second Edition

10

DEFAULT RISK

For any bond, default by the issuer is always a possibility. The word default means violation of any of the terms of the agreement between the borrower and lender. The most serious violations are nonpayment of coupon and principal, but other violations of the agreement can occur. If the violation of the agreement is minor, the parties may renegotiate the contract. But if the agreement violations are significant, the debtholders may force the issuer into bankruptcy. Bankruptcy is a formal legal proceeding administered by special bankruptcy courts.

For the US Treasury, default on Treasury debt obligations is unlikely. The reason is simply that the Treasury can always borrow more money from the Federal Reserve, which has the power to create money. However, default on municipal bonds, mortgages, corporate bonds, and bank debt is always a possibility.

Default on Municipal Bonds

For municipal bonds issued by state and local governments, default is possible. Municipal bonds are of two types – general obligation (GO) bonds and revenue bonds. GO bonds are backed by the full taxing authority of a municipality and have relatively low probabilities of default. Revenue bonds are backed by the proceeds from a specific project, such as a toll highway, and have a much higher default probability. There are many varieties of revenue bonds and the default risks can vary widely. Many municipal bonds carry insurance against default. In the event of default by the issuer, the insurer ...