When a debtor is unable to repay their debt at the date required, they must ‘default’ on their loan. A default can apply to any occurrence where the legal obligation of a debtor to repay his/her borrowings at a particular date and agreed rate, both usually stipulated in a contract. For instance, if a person cannot make a repayment on a mortgage or car loan, a default occurs. You may also hear the word ‘default’ used to describe the debts of a country, which is known as a ‘sovereign default’. Argentina is a good example of this, having been unable to repay a large amount of its bondholders recently in 2014, and infamously back in 2001 (the largest sovereign debt default in history on $100bn owed to the World Bank).
Bear in mind that defaults do not only apply to failures to pay interest or principal at a scheduled time (known as a debt service default). The term has also evolved to be applied to situations when affirmative or negative covenants in debt contracts are broken. For example, an affirmative covenant might require a firm to maintain a particular level of capital, or a financial ratio such as working capital/short-term liquidity. A negative covenant might stipulate that the company should prohibit or limit actions which might reduce the likelihood of creditors getting repaid, such as the sale of assets or payment of dividends in difficult financial situations. If the firm should break either covenant, it has committed technical default, and legal action might sometimes be pursuit.
A word of caution: a frequent mistake beginners make when learning about various situations of being unable to pay off debts is to confuse default with insolvency and bankruptcy, either assuming the terms are indistinguishable or that the occurrence of a default means the debtor in question is either insolvent, bankrupt, or both. This is incorrect. A default may refer to just one debt repayment that a debtor should have paid but was unable to. Insolvency is the legal term used to describe a debtor who cannot pay their debts in a more general sense. Bankruptcy is a legal discovery which imposes court supervision over the finances of financial entities which have defaulted or are insolvent – for example, by forcing them to liquidate their assets to repay debts.
A default is usually a last resort for a business or person, as it will often have negative financial implications. For example, defaulting on a debt can place the debtor in tight financial straits in future, as the lender is likely to see it as a sign that they will be unreliable for future repayments. Default is also, for obvious reasons, not ideal for the lender either. The average recovery rate from bonds from 1977 to 2011 was just 42.05% according to The New Case For High Yield, a report from Peritus Asset Management, meaning high yield bonds costing £100 would return roughly £42 back if default occurred. In the situation of a bond, the bondholders can force a defaulting debtor into bankruptcy, which would allow them the opportunity to claim the assets of the debtor as collateral for the debt. However, in many cases creditors will not receive their full repayments in the event of a default, and are asked to accept debt restructuring arrangements instead, with lower total repayments. It’s always advisable to be picky about who you lend to to avoid the risk of default. This is a big part of why credit checks and ratings are such an important feature of modern banking.