Bonds are debt instruments, or loans, in which the company borrows the amount of the bond and in return pays interest at regular intervals, with the principal being due upon bond maturation. A convertible bond is a bond that can be converted at some point into a different security, usually common stock.

Bonds are less volatile than stock and are attractive to investors because they are guaranteed a fixed rate of return in the form of interest payments. Since there is a legal agreement to pay back the bond's principal value plus interest, bondholders have more claim to the company's assets than do stockholders. This can be extremely important in the case of company bankruptcy, since bondholders will be repaid before stockholders.

However, since bonds are less volatile and risky, bondholders do not usually get to share in a company's growth. Therefore, some companies offer convertible bonds to allow bondholders to participate in a company's financial success. Companies also benefit from convertibility because a fixed pay out now becomes a security that is driven by market prices. The convertibility of a bond offers flexibility, and investors are able to take on more risks and rewards.

When bonds are converted, they can be based on a fixed formula or a market price formula. The fixed formula converts bonds into common stock based on a fixed price, and includes provisions to limit stock dilution when the bonds are converted. The market based price formula is less conventional. It protects the bondholder against price declines but negatively impacts both the company and stockholders. This is because it can lead to stock price reductions and these bonds are commonly known as “floorless,” “toxic,” and “death spiral” convertibles.

When buying bonds, it is important to understand what type is being offered. For additional information, visit the Securities and Exchange Commission (SEC) Web site.