Convertible bonds are a special type of bond that can be converted into stock at a predetermined date and price in the future. A favorite of companies with weak earnings or limited history, convertible bonds allow companies to borrow money at a lower interest rate than traditional bonds.

How convertible bonds work
A revolutionary car company named Tesla Motors (NASDAQ:TSLA) has figured out how to make a speedy electric car. But to make them in mass quantities, Tesla needs to build a new battery factory.

A relative upstart in the world of automobiles, it doesn't have sufficient retained earnings to build a factory. It needs to borrow the money from investors to finance the construction project.

The factory won't start producing revenue, let alone a profit, for years down the road. Thus, Tesla isn't just looking for a way to borrow money; it's looking for a way to borrow money with a really low interest rate that it can afford to pay.

It goes to the market with an interesting proposition. It will sell five-year convertible bonds to investors for $1,000 each. The bonds will pay annual interest of 0.25% per year, or $2.50 in interest per bond, per year. After five years pass, the company will return the investors' $1,000 investment.

In all, investors will turn their $1,000 investment into $1,012.50 in five years.

Tesla knows that offering 0.25% in annual interest isn't the kind of return investors need. Most could get a better return putting their money in a savings account. The carmaker sweetens the offer by announcing that it will allow investors to convert their bonds into 2.8 shares of stock at any time when its shares trade above $360 per share. Shares currently trade for about $250 each.

This just got interesting!
What started out as a really unattractive bond -- who wants to make just 0.25% per year? -- turned into a potentially very attractive offer.

Let's look at this from the investors' perspective. Two things can happen.

1. Tesla shares never jump above $360 per share in the next five years. In this case, the investor will at least receive a 0.25% annual return on his investment in the form of interest on his bond. It's not great, but as long as Tesla doesn't go bankrupt, at least he won't have lost anything. 

2. Tesla Motors could turn out to be a remarkable success. If its shares skyrocket, the convertible bonds can be swapped for stock at the conversion price of $360 each. Suppose its shares double from $250 to $500 in four years. At that point, the investor can swap his convertible bond, worth $1,000 at face value, for 2.8 Tesla shares, which are currently valued at $1,400 at the current market price.

Add the $1,400 in stock to $10 in interest earned over four years, and the investor nets $410 in profit, or 41%, which is a very respectable return in just four years.

Risks and rewards
Both the borrower and investor have to accept some tradeoffs with convertible bonds. The investor takes the risk that the borrower's stock price languishes, and thus he earns only a tiny bit of interest on his investment. Worse, the company could fail, leaving him with less than he originally invested in the bond. On the other hand, the borrower risks having to issue stock worth much more than the face value of the bond if its share price rises.

As for the Tesla example, it makes use of some rounded numbers to keep things simple. (In reality, Tesla's $1,000 bonds were convertible into messy numbers of 2.7788 shares at a price of $359.87 per share.) Tesla raised billions of dollars by selling convertible bonds in 2014.

The electric-car maker is just one of many borrowers that have used convertible bonds to save on interest expenses, and it certainly won't be the last. And at least so far, Tesla has enjoyed the better end of the deal; with about 3.5 years to go, its stock hasn't hit the conversion price.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.