Temporary Default

Temporary default is a situation in which a debt issuer fails to meet loan obligations but remains likely to resolve the situation in some way.

Temporary default occurs when circumstances cause a borrower to breach one or more elements of a debt contract. For example, a short-term squeeze in cash flow may force a borrower to delay timely payment on a loan or other debt instrument. Debt issuers have a contractual obligation to make timely payments of principal and interest and to follow any debt covenants outlined in a loan contract. Any failure to meet these obligations over the course of the loan places the borrower in default.

Loan agreements typically list the consequences of default, which may include penalty payments, automatic changes to interest rates or loan termination accompanied by a demand for immediate repayment of the outstanding principal of the loan. In cases where a borrower clearly has the means, opportunity and desire to continue to rectify the situation and continue to meet loan obligations, it benefits both the borrower and creditor to take less-drastic actions. Creditors consider these situations to be temporary defaults when they can reasonably expect a borrower to meet their obligations eventually.

In a best-case scenario, a borrower in temporary default returns to compliance with loan obligations. For example, a borrower could make back payments and return to timely payments on the debt going forward. Creditors such as bondholders might only see a delay in interest payments in this situation. The longer the delay in payment, however, the greater the risk that creditors will take a loss on some portion of their interest or principal payments. If the borrower’s troubles continue to mount and lead them to declare bankruptcy, the creditor would likely have to compete with other debt-holders to recover as much of the investment as possible. In this case, the worst-case scenario would be a total loss of outstanding interest and principal.

The distance between the best-case and worst-case scenarios covers a broad territory of default risk. Any form of default exposes borrowers to higher interest rates, since their inability to meet loan obligations makes it riskier for lenders to extend them credit. When a borrower enters temporary default, creditors may find it advantageous to offer some form of debt restructuring in order to ease repayment hardships while keeping the creditor whole.

Bond issuers may also offer bondholders an exchange, for example, swapping current bonds with lower-yielding issuances and longer durations. This arrangement benefits investors by replacing bonds in danger of default with a potentially less-risky issuance. At the same time, the issuer can begin to repair any damage to its credit rating by making timely payments over the duration of the longer loan.