What is a convertible bond?

A convertible bond is a specific type of financial instrument that allows the holder to convert their bond into a predetermined number of shares of the issuing company's stock. This feature essentially combines elements of both debt and equity, which is why it is considered a compound instrument.

The debt component is represented by the bond itself, which typically pays interest to the holder. The equity option is represented by the right to convert the bond into shares of the company's stock, thus providing potential upside if the company's share price increases. Investors might be attracted to convertible bonds because they offer the fixed income of a bond while also providing the opportunity to benefit from increases in the company's equity value.

Other options do not capture the essential characteristics of a convertible bond. For instance, a bond that pays variable interest does not have the conversion feature; merely being variable does not define it as convertible. A bond that converts to cash refers to a typical bond's redemption upon maturity, which is unrelated to conversion to equity. Additionally, a bond secured by assets pertains to secured bonds, not specifically convertible bonds, as it does not inherently involve an equity conversion feature.