A credit event represents a critical financial development indicating that a borrower—whether a corporation, municipality, or government—is unable or unlikely to meet its debt obligations. These events are legally defined in credit derivative contracts, especially credit default swaps (CDS), which function as insurance against default.
Key Triggers of a Credit Event
The International Swaps and Derivatives Association (ISDA) sets standardized definitions for credit events, which typically include:
- Bankruptcy: The borrower formally files for bankruptcy due to insolvency, such as a company entering Chapter 11 to reorganize debt. Learn more about bankruptcy types and implications in our Bankruptcy Reaffirmation Agreement article.
- Failure to Pay: A borrower misses a scheduled principal or interest payment after any agreed grace period expires.
- Restructuring: The borrower alters the debt terms unilaterally, often reducing payments, extending repayment schedules, or changing interest rates, disadvantaging original lenders. Read more about Debt Restructuring.
- Repudiation/Moratorium: Typically refers to governments suspending or refusing repayment of debts.
- Obligation Acceleration: A default on one debt triggers all related obligations to become immediately due.
How Credit Events Affect Investors and Markets
Investors holding bonds or loans can hedge credit risk by purchasing CDS contracts from financial institutions. When a credit event occurs, an ISDA Determinations Committee confirms the event, triggering settlement. The CDS seller then compensates the buyer for losses related to the defaulted debt.
This mechanism aims to limit losses and manage risk but can also influence wider financial markets. For example, during the 2008 financial crisis, credit events like Lehman Brothers’ bankruptcy triggered significant CDS payouts, amplifying systemic risk.
Broader Economic Impact
Credit events can signal financial instability beyond individual borrowers. They may reduce investor confidence, tighten credit availability, and increase market volatility. Understanding these signals helps grasp the health of both financial markets and the broader economy.
FAQs
Can individuals experience credit events?
The term is mainly used for corporate, municipal, or sovereign debt within financial markets. Individual bankruptcies are not typically termed credit events.
Who decides if a credit event has occurred?
The ISDA Determinations Committee reviews evidence and issues binding decisions on credit event status related to CDS contracts.
Is a credit event always negative?
For borrowers, yes—it indicates distress. For protection buyers (investors with CDS), it may result in compensation mitigating losses.
For more detailed coverage of related topics, visit our pages on Bankruptcy Reaffirmation Agreement and Debt Restructuring.
Sources:
For authoritative tax-related guidance related to bankruptcy and restructuring, also consult IRS resources.