Busted Bond

A busted bond occurs when an issuer fails to pay the required interest payments or principal amount to the debt holder (or both). To meet their debt requirements, busted bond issuers, considered bankrupt, would have to liquidate assets to repay the bondholders. The term "busted bond" can also refer to convertible debt securities that have an insignificant conversion value because conversion price is much higher than the market value of the underlying securities. 

If a busted bond occurs, the issuing firm would be forced to file for bankruptcy, as the terms of their debt had been violated. Busted bonds in default are worth much less than the discounted value of their cash flows. Busted bonds that arise from a decline in the price of the underlying asset, such as convertible bonds, are not in violation of their covenants - they are simply worth less than equivalent securities with embedded options and are closer to being in the money. 

Bond covenants are contained in the bond indenture required of government and corporate bond issues. They are legally binding agreements meant to protect both the issuer and the bondholder and outline the obligations of each party. Two of the basic affirmative covenants contained in bond indentures is the requirement for issuers to make periodic interest or coupon payments on a schedule set forth in the indenture and to return a bondholder’s principal at maturity or the call date if a bond is callable.

The priority of payment for bonds in an issuing company’s capital structure can make fixed income more attractive than other asset classes in terms of principal protection. In the event of bankruptcy, busted bonds would be the first obligation paid by the company, ahead of convertible bonds, preferred stock and common stock.

Bonds can become busted in several ways. The most common cause for a corporate bond is when a company’s revenues decline to the point that it can no longer expenses, including bond obligations. Revenue could drop due to poor business conditions, increased competition or a negative event that creates unexpected expenses such as an adverse legal ruling. Some companies may be able to accept short-term loans or tap existing credit facilities to temporarily cover a shortfall, however some covenants prevent issuers from taking on additional debt.

Municipal bonds issued by state or local government and other public entities can also become busted. This can occur when an issuer’s revenue-producing ability becomes impaired for reasons such as a local recession, declining tax base or spiraling expenses such as public employee pension or health care obligations.