What is a Busted Convertible Security
Busted convertible security refers typically to a convertible bond with an underlying stock trading well below its conversion price. As a result, the convertible bond trades as regular debt because there’s very little chance that it will ever reach the convertible price before maturity.
A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder.
BREAKING DOWN Busted Convertible Security
Busted convertible security describes the behavior of a convertible bond which has lost considerable value as a potential convertible option. A convertible bond is a hybrid-type of corporate security that owners can exchange for shares of the company's common stock. Each bond has a face or par value that the owner can redeem for a fixed number of shares. The number of shares has a basis on the conversion ratio.
For example, if a convertible bond has a face value of $500 and a conversion ratio of 10, every $50 of the face value would be redeemable for one share of company stock. That conversion feature can be useful to the owner if the value of the underlying stock increases before the bond they’re holding matures. Say the stock price of the company climbs above the conversion price of $50, to $60 per share. The owner could elect to convert their $500 bond (worth ten shares of company stock) into equity worth $600 (10 shares x $60/share). Once converted, the owner can hold that stock or sell it on the market.
But if the price of the underlying stock decreases, falling below 50% of the conversion price, the security is ‘busted.’ In that case, the bond behaves much like an out-of-the-money option. Take the same example involving a $500 convertible bond. If the value of the underlying stock fell to $25, or lower, the benefit of the security’s convertible feature is almost worthless since it’s unlikely that stock price will recover. There’s no incentive for the owner to convert the security to equity because its investment value, or what a similar non-convertible bond would fetch on the market, is worth more than the conversion value. The conversion value is the amount realized by exchanging the bond for equity.
Trading Busted Convertibles
Some investors have found success in trading busted convertibles. While the probability of converting the security into stock is remote, busted convertibles typically trade at prices and yields similar to traditional non-convertible bonds of similar maturities and risk. Meanwhile, should the underlying company stock happen to rebound before maturity, the bond’s convertible value would also appreciate, and the security could become valuable.