A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion of its nominal value to either cash or a specified number of common shares of equal value. A corporation issues a convertible bond to take advantage of reduced interest rates, since the presence of the conversion option provides upside potential for the bondholders, and these bonds tend to demand lower interest rates compared to standard nominal bonds. Another advantage of issuing convertible bonds rather than equity is the tax deduction of interest, which lowers the cost of capital for a company. Also, as the bonds are converted to equity, a company has no more obligations. However, depending on the number of additional shares issued as a result of the conversion, shareholders' equity value declines as a result of stock dilution.
Convertible bonds are typically issued by firms with substandard credit ratings and high expected growth. For example, in 2014, Tesla Motors issued $2 billion convertible bonds to finance the construction of the Tesla Gigafactory in Nevada. Because Tesla reported low or negative earnings over the previous few years leading up to 2014, raising capital for this project using standard nominal bonds was prohibitively expensive as the interest rates demanded by investors were very steep. However, with the conversion option, the interest rates on Tesla's convertible bonds ranged between 0.25% and 1.25%.
When convertible bonds are converted to equity by bondholders, a significant stock dilution could occur, which may result in a substantial reduction in shareholders' value per share. Thus, if a company wants to issue stock through a secondary offering in the future, it may not be able to raise as much capital due to stock dilution from convertible bonds.