Event of Default
Definition
A contractually defined trigger in structured credit documents that grants debt holders remedies including acceleration (demanding immediate repayment), replacement of manager or servicer, and forced liquidation of assets. Events of default are distinct from covenant breaches or test failures—they represent fundamental structural failures such as missed payments, bankruptcy, or material breaches of representations and warranties.
Why it matters
Events of default fundamentally distinguish between normal structural stress (test failures, cash flow diversion) and terminal events. Understanding this distinction prevents panic during market volatility. In March 2020, thousands of CLOs experienced OC/IC test pressure and price declines, but virtually zero events of default occurred. True events of default are rare in properly structured deals because cash flow diversion and deleveraging cure most problems before reaching default. When events of default do occur (2008-2009 vintage CLOs, certain ABS), the remedies reshape the capital structure and typically result in significant equity losses.
Common misconceptions
- •Covenant test failures (OC, IC, WARF) are NOT events of default. They trigger cash flow diversion, not acceleration or liquidation. The structure continues operating normally with diverted cash flows.
- •Missed scheduled distributions to equity or subordinated debt are NOT events of default in most structures. Only missed payments to senior debt (after cure periods) typically constitute default.
- •Market price declines are NOT events of default. A CLO AAA tranche trading at 70 cents does not trigger default if payments continue on schedule.
- •Manager replacement can occur without event of default. Many structures allow noteholders to replace managers through vote if performance deteriorates, even without formal default.
Technical details
Common events of default in CLOs
Typical CLO events of default include: (1) Failure to pay interest or principal on senior tranches by payment date (after grace period, typically 3-5 business days). (2) Bankruptcy or insolvency of issuer or manager. (3) Material breach of covenants that remains uncured after notice period (30-60 days typical). (4) Breach of certain representations and warranties that materially impacts deal. (5) Failure to maintain required insurance, ratings, or regulatory compliance. (6) Unauthorized asset sales or pledge of collateral. Note: OC/IC test failures are explicitly NOT events of default in standard CLO structures—they trigger diversion, not default.
Cure periods and notice requirements
Most events of default include cure periods before acceleration rights trigger. Payment default: typically 3-5 business days grace period (if payment not made by day 5, default occurs). Covenant breach: typically 30-60 days after notice to cure. Representation breach: depends on materiality; some are immediate defaults, others allow 30-day cure. Bankruptcy: immediate event of default, no cure period. The notice and cure structure prevents technical defaults from minor administrative errors. However, it also creates ambiguity—is day 4 of grace period a crisis or routine? Market participants watch cure period countdowns closely.
Remedies available to debt holders
Upon event of default (after cure periods expire), debt holders can typically: (1) Accelerate—declare all amounts immediately due and payable. Forces liquidation of collateral pool. (2) Replace manager/servicer—appoint new party to manage or service assets. (3) Direct actions—control asset sales, trading, distributions. (4) Seize collateral—take possession of assets (though typically through trustee). (5) Enforce security interest—foreclose on pledged assets. Exercise of remedies typically requires majority or supermajority of impacted tranche (66% or 75% common). Remedies are sequential—acceleration is nuclear option, typically last resort after manager replacement fails.
Historical event of default frequency
Events of default in investment-grade structured credit are rare. CLO senior tranches: Near-zero event of default rate historically, including 2008-2009 crisis. AAA CLOs paid on schedule even when trading at 60-70 cents. CLO equity/junior debt: Higher default frequency in severe vintages (2006-2007 deals saw some equity/BB defaults during 2008-2010 as extended cash flow diversion led to maturity defaults). ABS/MBS: Higher default rates in subprime RMBS (2007-2009) and certain CMBS vintages, but agency MBS effectively zero defaults. This explains yield spreads—AAA CLOs trade at L+120-150 vs. L+300-500 for BB, reflecting default risk differential.
Event of default vs maturity default
Two types of default: (1) Payment default—failure to make scheduled interest or principal payment. This is classical event of default. (2) Maturity default—inability to repay at final maturity. In CLOs, maturity defaults can occur without payment defaults if cash flow diversion persists for years, preventing debt paydown. Example: 2007 vintage CLO with 12-year life. OC test fails in 2009, cash diverts to debt for 8 years. By 2019 maturity, some debt remains outstanding but no cash available. This is maturity default despite no missed payments during life of deal. Equity and junior debt suffer total loss, but senior debt typically recovers significant value through extended maturity or restructuring.
Cross-default and cross-acceleration
Many structured credit documents include cross-default provisions: if one tranche defaults, it may trigger default in other tranches or related vehicles. Example: Manager defaults on CLO A, triggering removal provisions in CLO B, C, D under same manager. Or: CLO issuer defaults on senior tranche, automatically triggering default on all subordinated tranches. Cross-default provisions multiply impact of single events and create contagion risk within programs. However, most CLO structures are bankruptcy-remote SPVs, so issuer default on one CLO does NOT trigger default on other CLOs in same program. Verify cross-default language in indenture—varies by deal and manager.