A default is a default on a loan that is required by law or agreed upon by the parties involved (usually the debtor and creditor). Loan covenants often include terms on interest and maturity.
The exact legal definition of default may vary in wording, and the specific semantics may vary slightly. However, the above definition captures the nature of default in most countries. The term itself can be used as both a noun and a verb with a similar meaning. That is, the debtor can "avoid default" (noun) or "avoid default" (verb).
Summary
- A default occurs when the debtor fails to fulfill one or more terms of the contract agreed by all parties.
- There are two types of default: debt service default and technical default.
- Defaults are distinct from illiquidity, insolvency, and bankruptcy.
Default value types
Since the definition of default is a breach of the terms of a loan between a debtor and a creditor, there may be many conditions that can be breached. Generally, two types of non-payments refer to the different nature of the breached agreements:
1. Debt service default
Debt service defaults occur when a debtor misses a scheduled payment of interest, principal, or both. Among the general public, debt service default is what is commonly thought of when the term "default" is used.
2. Technical default
Technical defaults are defaults that occur when a positive or negative covenant is violated. Affirmative and negative covenants cover all contractual terms except for payment clauses.
affirmative covenants
Affirmative covenants are terms or conditions that specify a minimum (or maximum) financial or capital ratio that a lender (corporate or individual) must comply with before a loan is repaid.
Some examples of affirmative covenants:
- Tangible Net Worth
- Working capital/short-term liquidity
- Debt service coverage
If the coefficient falls outside the specified range in the loan agreement, the positive covenant is violated and a technical default occurs.
Negative covenants
Negative covenants are terms or conditions in a loan agreement that restrict or prohibit certain corporate activities that are considered potentially harmful to lenders.
Examples of negative covenants include:
- Sale of a specific quantity/type of asset
- Payment of dividends
- Redemption share
While technically possible, violations of negative agreements are much less common than violations of positive terms due to the nature of the provisions. While negative covenants simply prevent corporate action that is within the full control of management, positive covenants depend on performance that is not under management's control.
Difference from related terms
The following terms are often confused with the default value:
- Illiquidity
- Insolvency
- Bankruptcy
The above terms have by default related meanings, but with a clear, if sometimes subtle, difference. They are briefly defined below to outline the subtle differences. However, you can check out the articles linked above for more information on these terms.
- Illiquidity is a condition in which cash or other forms of liquid assets are insufficient to pay off debts. By itself, it does not refer to a specific point in time.
- Insolvency is a legal term for a debtor's inability to repay a debt.
- Bankruptcy is a legal status and process that insolvent debtors obtain and enter into as a method of getting out of debt.
sovereign defaults
Interestingly, sovereign governments can also default, known as "sovereign default".
By definition, sovereign governments control their own public affairs, and thus there is technically no international arbitrator for forced redemption. However, creditor countries will often apply pressure through diplomatic strategies such as trade restrictions and even threats of war.