Bonds in Default
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 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.