A convertible bond is type of bond that can optionally be converted into shares of stock in the issuing company at some pre-announced ratio. A convertible bond will have a lower coupon rate for which the holder is compensated for by the value of the holder's ability to convert the bond into shares of stock. In addition, the bond is usually convertible into common stock at a substantial premium to its market value.

From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. However, in exchange for the benefit of the reduced interest payment, the value of shareholder's equity is reduced due to the expected dilution should the convertible bondholders convert their bonds into new shares.

From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. In order to value the convertible bond, one calculates the present value of future interest and principal payments at the cost of debt and adds the present value of the warrant.