Retirement Income Blog

What Happens to Bondholders When a Company Goes Bankrupt?

Seniors and retirees like bond investments because they provide a steady income, diversify a stock portfolio, and are backed by the issuer’s financial strength. But things don’t always go as planned. Companies occasionally have financial problems and must file for bankruptcy as you well know.

Investors holding bonds in bankrupt companies can at least have the comfort in knowing that as unsecured creditors they are second in line for payment. Secured creditors, those with claims backed by collateral, such as equipment or real estate, are paid first. Stockholders come last and that is only if there is any money left after the creditors have been paid.

There are two general forms of bankruptcy: Chapter 7 and Chapter 11. With Chapter 7, the company is liquidated and bondholders should file a claim to receive a portion of the value of their bonds. In Chapter 11 proceedings, however, the process is quite different.

Chapter 11 allows the corporation to reorganize. Its bonds might continue to trade, but holders will not receive principal and interest payments. As a result, a default could occur, and the value of the bonds might decline significantly. Or the court may approve an exchange of the old bonds for new ones, which could have a lower value.   The problem is that the fortunes of corporations change.  The highly rated General Motors bond you may have purchased with an AA rating years ago may now be rated CCC as General Motors clings to financial life.

How can you find out if a company that you lent money to by purchasing a bond has filed for bankruptcy or if the safety has declined?  First, if you have a sizeable portfolio and a good retirement consultant, he will keep you informed.  Secondly, LOOK at your monthly brokerage statements when they arrive.  The first hint of trouble is a decline in bond value from one month to the next.  TV reports, newspapers, and financial magazines often give an account of companies that recently declared bankruptcy or have trouble. The company will also send you information on the reorganization plan and ask you to vote on it. And if a financial institution holds the bond for you, it should forward everything from the company.

If you would like a free credit report on bonds you currently own, here are two web sites to check

http://www.moodys.com/cust/default.asp.  Register for a free account and you can return to this site periodically to check your bonds.  Should your broker do this for you?  One of the problems is that the broker gets paid a commission when you buy the bond.  he has little if any incentive to keep you informed unless you continually do business with him.
Another site with information is http://www.fitchratings.com/

Unfortunately as with stock investing where you can get a lot of information on the common shares of public companies, the transparency and visibility of bond investing information is poor.

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Use of nontraditional mortgages has increased among home buyers, according to a Wall Street Journal Online/Harris Interactive poll–could you benefit too?

There are four major types of non-traditional mortgages:

1. Interest-only mortgages, which have received considerable media attention as home prices have skyrocketed, allow borrowers to pay interest but no principal during the early years of the loan.
2. Piggyback mortgages combine a standard first mortgage with a home-equity loan or line of credit, thereby allowing the borrower to avoid paying private mortgage insurance or higher interest rates on jumbo loans.
3. Miss-a-payment mortgages let borrowers skip up to two mortgage payments per year, and up to 10 payments over the life of the loan, without damaging their credit rating.
4. Payment option mortgages give borrowers four-payment options–not when they take out the mortgage, but every single month.
   These include
   1) a payment based on a 30-year amortization table which, if made every month, will pay off the mortgage in 30 years;
   2) a payment based on a 15-year amortization table, which, if made every month, will pay off the mortgage in 15 years;
   3) an interest-only payment, in which the principal balance will remain unchanged; and
   4) a partial-interest payment, in which part of the interest is deferred and added to the principal balance.

The chart below illustrates the reduced payment on an interest-only loan.

Source: Archer Pacific, as of October 2006 (www.archerpacific.com/compare%204%20mortgage%20loans%20calculator.html). This example is hypothetical. You may not be eligible for any of these loans, and if you are, interest rates on loans will vary based on your financial circumstances and prevailing interest rates.

If you want to buy more house than you can afford with a traditional mortgage, these options can be good tools, and more people are using them. The Wall Street Journal Online/Harris Interactive survey found increased usage of three of four types of nontraditional mortgages from 2005 to 2006.

But borrower beware: Non-traditional mortgages can be riskier than standard fixed-rate or adjustable-rate mortgages. For example, with payment option mortgages, borrowers who elect to make the minimum payment could see their loan balance rise, rather than fall. That’s because the deferred principal and interest payments get tacked onto the home owner’s total debt, a process known as negative amortization.

Specifically for seniors are reverse mortgages.  If you have sufficient equity, these will allow you to pay off your traditional mortgage and even pay you.

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