What is a busted convertible security? Definition, Trading Strategies, and Risks

A convertible bond is a hybrid security that offers investors the option to convert their bonds into a predetermined number of shares of the issuing company’s common stock. This conversion option provides bondholders with the potential for capital appreciation if the stock price rises significantly above the conversion price.

A convertible bond becomes “busted” when the price of the underlying stock falls substantially below the conversion price, typically by more than 50%. In this scenario, the convertible bond behaves more like a traditional bond rather than an equity instrument because the likelihood of conversion is minimal.

For instance, consider a convertible bond with a face value of $500 and a conversion ratio of 10, allowing the bondholder to exchange every $50 of face value for one share of stock. If the stock price drops below 50% of the conversion price (e.g., below $25 in this case), the conversion feature becomes economically unviable, rendering the bond essentially worthless as an equity investment.

While busted convertible securities may seem unattractive due to their diminished conversion potential, they often trade at prices and yields comparable to traditional non-convertible bonds with similar risk profiles and maturities. Investors may find these securities appealing for their potential to provide bond-like yields coupled with the possibility of equity-like returns if the underlying stock experiences a significant rebound.

Investing in busted convertibles involves both risks and potential rewards. On the one hand, the diminished likelihood of conversion means investors may miss out on potential equity upside if the underlying stock recovers. On the other hand, these securities offer the advantage of fixed income streams, akin to traditional bonds, which can provide stability to a portfolio even in volatile market conditions.

A busted convertible security refers to a convertible bond where the underlying stock trades significantly below its conversion price, rendering the conversion option economically unviable.

Investors may trade busted convertibles based on their attractiveness relative to traditional bonds, considering factors such as yields, maturity dates, and the potential for stock price rebounds.

The primary risk of investing in busted convertibles is the limited potential for capital appreciation if the underlying stock fails to recover, coupled with the opportunity cost of missing out on equity upside.