How Does a Convertible Bond Function as a Hybrid Financial Instrument?

A convertible bond is a hybrid instrument because it combines the features of a debt instrument (a bond) and an equity instrument (a stock option). It pays regular interest like a bond but gives the holder the option to convert the principal into a specified number of shares of the issuing company's common stock.

This embedded option provides the holder with potential equity upside while retaining the downside protection of a bond.