Quick Answer
A defaulted municipal bond stops accruing interest and trades flat, meaning the buyer pays no accrued interest and the price reflects only the market's estimate of recovery value. Income bonds and zero-coupon bonds also trade flat, but for different reasons.
When a municipal bond issuer stops making payments, the bond enters default and trades differently from normal bonds. This pricing distinction is frequently tested.
How Do Defaulted Bonds Trade?
When a municipal bond is in default (the issuer has failed to make interest or principal payments):
- The bond does not accrue interest; interest stops accumulating
- The bond trades flat (without accrued interest); the buyer does NOT pay accrued interest to the seller
- The price reflects the market's estimate of recovery value (what investors expect to recover)
Normal Bond vs. Defaulted Bond
| Feature | Normal Bond | Defaulted Bond |
|---|---|---|
| Accrues interest? | Yes | No |
| Buyer pays accrued interest? | Yes | No (trades flat) |
| Price reflects | Market value + accrued interest | Recovery value only |
Other bonds that trade flat:
- Income bonds (also called adjustment bonds): corporate bonds that pay interest only if the issuer earns sufficient income
- Zero-coupon bonds: no coupon payments are made, so there is no accrued interest to add
Exam Tip: Gotchas
- A bond in default does NOT accrue interest. No exceptions.
- "Trades flat" means the buyer pays NO accrued interest. The price is all the buyer pays.
- Income bonds also trade flat. These are corporate bonds, not municipal bonds. A common mix-up is confusing the two.
What Should You Check on Exam Day?
- Confirm a defaulted bond does not accrue interest and the buyer pays no accrued interest at settlement.
- Recognize other bonds that trade flat for different reasons: income bonds (interest paid only if earned) and zero-coupon bonds (no coupon to accrue).
- Remember income bonds are corporate securities, not municipal, even though they share the "trades flat" feature with defaulted munis.