What happens when a bond defaults

What happens in an "event of default"

Failure to pay interest or principal on the payment due date is considered an “event of default”. If the issuer fails to observe financial covenants, such as ensuring that the net borrowings to total equity does not exceed a certain ratio, this could also constitute an “event of default”.

The issuer will define the “events of default” in the terms and conditions of the bond which should be disclosed in the offer document given to you. When a default happens, you may lose all or a substantial part of your investment.

How to know if a bond issuer is in trouble

You, as an investor, must monitor your own investment. If the bond or the issuer is listed on the Singapore Exchange (SGX), you should keep a look out for announcements relating to the bond or the issuer.

If the issuer is listed on SGX, it s required to announce its financial statements on a quarterly or half-yearly basis. Its annual report must also be made public.

If the issuer is not listed on SGX but its bonds are, its financial statements must nonetheless be disclosed regularly as approved by SGX. Such disclosure arrangements can be found in the offer documents for the bonds. You can look at the periodic financial statements, the annual report, and other documents the issuer may publish to keep up to date on the issuer’s financial situation.

There could also be news reports on the financial position of the issuer, or on the issuer’s industry outlook.

You need to assess whether to hold on to the bonds, or to sell part or all of your investment. Seek professional advice if needed.

Note: If you are a bondholder and have some concerns about the company’s compliance with SGX’s listing rules, or about possible market misconduct, you may wish to contact SGX. SGX is the frontline regulator and is required to administer a sound regulatory framework to maintain a fair, orderly and informed market.

What happens when an issuer defaults or is likely to default

There are three possible outcomes: debt restructuring, winding up or judicial management.

Debt restructuring

When an issuer faces financial distress, it may decide to restructure its debt. The objective of debt restructuring is to renegotiate and modify the terms of the bond to provide relief to the issuer who could otherwise default on payments.

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

• Extending the tenure of the bonds such that the issuer can repay the principal at a later date

• 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

To achieve this, the issuer typically engages bondholders in a consent solicitation exercise to seek bondholder approval to modify the terms of the bonds.

Consent solicitation exercises usually involve the voting for an extraordinary resolution to approve the proposed modifications. Bondholders can choose to vote in favour of the proposal by delivering voting instructions in accordance with procedures outlined by the issuer. You should review the proposed terms and explanations provided by the issuer when deciding whether to approve the proposal.

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.

Winding up

In general, a company can be wound up, or liquidated, in two ways: voluntarily, or by the court.

When a company is wound up, it ceases to operate its business, and the assets are sold off. The proceeds from the sale of assets would be paid to creditors (including bondholders) ahead of shareholders.

An issuer may structure its debt into different classes – senior debt and junior debt. Usually, secured debt is classified as senior debt while unsecured debt is classified as junior debt.

Among bondholders, senior debt is paid first, followed by junior debt. Bondholders may not necessarily get all or part of their monies repaid. It depends on the amount of proceeds from the liquidation. Holders of unsecured bonds, for instance, may not be paid at all if the issuer’s assets are not sufficient to pay the holders of secured bonds.

Judicial management

For a company incorporated in Singapore, 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.

Which should you opt for: debt restructuring, liquidation or judicial management?

If a debt restructuring proposal has been tabled, some investors prefer to accept the proposal because they take the view that debt restructuring gives them a chance of recovering at least part of their investment sum. Furthermore, liquidation can be a long process and there could be significant legal costs involved.

Some may take the view that there is too much uncertainty and prefer to require the issuer to repay the amounts owed under the bonds, failing which the issuer should be liquidated.

Others may be inclined to give the issuer a chance for its financial position to be improved through judicial management, which could mean eventual repayment of their investment sum.

The Companies Act, administered by the Accounting and Corporate Regulatory Authority (ACRA), applies to the judicial management and winding up of Singapore-incorporated companies. Companies that are incorporated in other jurisdictions are subject to the laws of those jurisdictions.

What is a trustee and what is its role?

A trustee is normally appointed by the issuer to represent the bondholders. Trustees are expected to exercise reasonable care and skill in carrying out their duties.

The duties and obligations of trustees for any bond issue are provided for under the trust deed (between the issuer and trustee) and the law.

The trust deed also contains provisions for the protection of the rights and interests of bondholders, such as a limitation on the amount that the company may borrow, as well as the procedures for convening meetings to consider matters that affect bondholders’ rights or interests.

The trustee acts for the bondholders on the terms contained in the trust deed. Bondholders should read the terms and conditions of the trust deed provided in the offering document. The issuer is obliged to promptly inform the trustee when it is aware of any event of default or when any condition of the trust deed cannot be fulfilled.

How can bondholders enforce their rights in a default?

Where the issuer is unable to meet its obligations under the bonds, bondholders could enforce their rights under the trust deed. Trust deeds often provide that bondholders who in aggregate hold a certain amount of the bonds (e.g. 25% of the principal amount of the bonds) can instruct the trustee to take action.
For instance, bondholders may request the trustee to give notice to the issuer that the bonds are immediately repayable following the occurrence of an event of default.

After the bonds become due and payable, bondholders may request the trustee to institute proceedings against the issuer - for example, to enforce the security (if the bonds are secured) or make a winding-up application.

Particularly where individual bondholder investments are relatively small, collective enforcement of the bondholders’ rights through the trustee allows bondholders to act as a cohesive group. It also serves as a safeguard against situations where individual bondholders, acting on irrational fears or in self-interest, may prematurely call on the repayment of debts against the issuer and cause overall greater losses for all bondholders.

In this regard, bondholders may sometimes choose to form an ad hoc committee and retain legal counsel, to consider the course of action and to communicate with the issuer and the trustee.

What is indemnity and pre-funding?

It is common for trust deeds to provide the trustees with the right to seek an indemnity and pre-funding from bondholders before taking the action requested by bondholders as the trustees may incur costs (e.g. legal expenses) and could be exposed to legal liability that may arise from taking such action.

Do note also that before a trustee acts on a request from bondholders, it would have to take steps to verify that the request comes from the beneficial owners of the bonds and that the value of the bonds held by the instructing bondholders meets the relevant threshold under the trust deed.

Where the bonds are held through custodians or nominee banks, the beneficial owners of the bonds should work with them to provide the necessary information and documents required by the trustee for verification. This process can take some time.