A convertible bond is a debt instrument which like other bonds pays interest at a specified rate for a specified period, but can be converted to common stock under specified conditions at the option of the bond holder.
Convertible bonds can offer the best of both worlds in that the yield of the bond helps support its market value even in bad times, but the ability to convert allows the bondholder to participate in the upside potential of the underlying equity. When the bond is bought and the money loaned to the company selling the bond, the parties agree to conditions including the interest rate to be paid and the formula for when and how to convert the bond into shares. Terms might include, for instance, that $40 in bond value will convert to one share. If the bondholder waits until the share price hits $45 before converting, that would create $5 of profit per share.
But the upside is not unlimited, as convertible bonds generally can be 'called' by the issuer, meaning the company will pay off the investor and buy back the bond. Also, because of the way convertible bonds work, they tend to pay lower interest rates than other vehicles. And a buyer may end up paying a premium, in that the conversion price ($40 per share in the above example) would be higher than a share's price on the day the bond is purchased.
So why do companies issue convertible bonds instead of just selling stock? Here are a few theories: It lets companies raise money that they might not otherwise be able to. Investors might be more willing to invest in a volatile company because of the downside protection. Issuing the bonds might cause less worry in current shareholders than diluting their ownership with more shares would.