What Happens to Bond Holders in Bankruptcy?

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Bonds can be issued by governments and corporations. Governments do not declare bankruptcy, but some municipal and foreign governments can default on certain bond obligations. Bankruptcy is declared by corporations that are unable to make payments on their current obligations. What happens to a corporate bondholder in bankruptcy depends on the bankruptcy proceedings and the type of bond he is holding.

Bankruptcy

A corporation declares bankruptcy to temporarily stop payments on its current obligations and to figure out what to do next. It has three options: liquidate, reorganize or sell out. In liquidation, it winds down its affairs and pays off creditors in an established order. In reorganization, it restructures its finances, including debt, by renegotiating terms with lenders and investors. In a sellout, it finds a buyer who typically injects cash and takes over on the agreed-upon terms.

Liquidation

Different types of bonds have different claims against corporate assets in liquidation. What happens to a bondholder depends on the type of bond he owns. Insured bonds are paid in full by the insurer. Mortgage bonds or secured bonds--bonds collateralized by specific corporate assets--are paid out of the proceeds from the sales of those assets. Senior bonds are paid out of the general corporate funds ahead of other bonds. The last in line are subordinated bonds and debentures that have a residual claim against any funds left over after other creditors have been paid.

Reorganization

In reorganization, a corporation intends to continue as a going concern but asks for relief from creditors. The type of relief it can get is determined through negotiation, which can mean a lower interest rate, forgiveness of a certain amount or type of debt, a debt-for-equity swap or other restructuring.

Takeover

Since bondholders as a group are considered senior creditors, they can collectively force a corporation into bankruptcy and take control of and restructure it on terms advantageous to them. Corporate raiders (deep pocket investors who buy whole companies) can take advantage of market opportunities by buying a company’s bonds for pennies on the dollar and restructuring the company to make a substantial profit. They do not need to own 100 percent of the bonds--just enough to take control. The remaining bondholders will get whatever the raiders get in the deal.

Buyout

If a corporation can find a strategic buyer who agrees to inject cash and take it over, bondholders will get whatever the deal between the corporation and the buyer stipulates.

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