MicroStrategy’s story is like a financial novel brought to life. An unlikely comeback from the brink of bankruptcy, a bold transformation from software vendor to Bitcoin maximalist in August 2020, messy legal entanglements, a charismatic savior-like leader, once-in-a-generation stock price performance, All of that is incredible.
Throw in the company’s massive stock issuance, convertible debt, and tsunami of insider sales, and the story gets even wilder. See previous article for a summary.
And the beat continues. Last month, the company surprised Wall Street by issuing its fifth convertible bond this year. The convertible is a $3 billion, five-year bond with a 0 percent coupon and a 55 percent conversion premium on a stock that was already trading at nearly three times its price. All of the net asset value of the Bitcoins you own goes toward funding your constant quest for more Bitcoins.
On paper, it’s genius. The plan is simple. Borrow at zero interest with a convertible bond, buy Bitcoin, and pay off the debt when the stock converts at a nosebleed price. As long as stock prices continue to rise, and as long as Bitcoin remains at least around $100,000, we are talking about one of the most successful feats of financial engineering in history.
This has not gone unnoticed. Just last week, Bitcoin miner Mara jumped on the bandwagon and issued $850 million in convertible notes to refinance its debt and, of course, buy more Bitcoin. The conditions were quite lenient. The coupon was zero percent and the conversion premium was 40 percent.
So are we witnessing the acceptance of Bitcoin by the bond giants? Access to Bitcoin through these convertible bonds is so attractive that investment obligations exclude them from cryptocurrencies. The argument is that bond investors are willing to concede surprisingly favorable terms to issuers. Given the sheer size of bond funds, even a small allocation to such securities can have a large seismic impact.
But while funds managed by heavyweights like German insurance company Allianz reportedly bought some of the early MicroStrategy convertibles, they probably weren’t here for the cryptocurrency revolution. . The real attraction lies in MicroStrategy’s stock price, or more precisely its volatility.
And MicroStrategy is an active and active accomplice in creating volatility in its own stock.
Convertible bonds are the equivalent of volatility in the capital markets. So there’s serious business in front (debt) and party in the back (equity). They start life as regular old debt, but with the kicker of an option to convert into equity at a predetermined price. For bondholders, this means downside protection (meaning they should get more money back) with upside potential. For businesses, built-in call options make trading more favorable to investors, allowing them to borrow at lower interest rates.
In this case, MicroStrategy has essentially created a financial product that is part loan and part lottery. How did they raise $3 billion with a 0% coupon and a conversion price of $672.40 per share when the stock was trading at $433? The answer lies in the explosive volatility in stock prices caused and exacerbated by Bitcoin holdings. This volatility greatly increases the value of the call option embedded in the bond, offsetting the cost of the bond itself. As a result, the company was able to borrow at much lower interest rates than traditional debt.
And it’s volatile. MicroStrategy’s inventory bounces from aisle to aisle with endless chaotic energy, like a hyperactive toddler let loose in a candy store. The 252-day historical volatility is currently 106% (meaning the average daily volatility is 6.6%!). The implied volatility of a 30-day option on the company’s stock is 2.5 times higher than a similar term option on Bitcoin itself. And MicroStrategy isn’t fazed by this. During its third-quarter earnings call, management trumpeted that MicroStrategy’s options were trading with higher implied volatility than S&P 500 stocks.
This reveals one of the contradictions surrounding the MicroStrategy story. Why does co-founder Michael Saylor relentlessly promote Bitcoin even though his company is buying it? Sho.
But for MicroStrategy, volatility is real currency. Saylor’s bombastic interviews, grandiose predictions and relentless social media posts are more than just noise, they’re fuel for the financial fire. There’s never a dull moment with the guy. The crazier the inventory, the better the conditions for your next convertible.
MicroStrategy has effectively designed and benefited from its own volatility. Prior to August 2020, the company’s stock had both realized and implied volatility in the low 30% range. However, once MicroStrategy was reinvented as a large purchaser of Bitcoin, volatility skyrocketed, first exceeding 70 percent and later exceeding 100 percent. This dynamic is self-reinforcing, as acquiring more Bitcoin amplifies stock price volatility and allows MicroStrategy to issue convertible debt on increasingly favorable terms, which it then uses to generate more Buy Bitcoin and experience even more volatility. And the cycle continues.
Historically, convertible bonds in the energy sector have traded at the “richest” level with implied volatilities of up to 35-40%, but recent issuance by technology companies has pushed them to levels of 40-45%. It’s rising. MicroStrategy’s convertibles are marketed with 60% implied volatility, an unprecedented level in equity-linked markets, according to IFR.
Investors in these bonds employ a variety of trading strategies to take advantage of volatility, but one classic approach is so-called gamma trading. This strategy involves buying bonds and shorting stocks, then dynamically adjusting the size of the short sale in response to stock price fluctuations to keep the total position and stock price neutral. The net effect is to buy the stock low and sell it high while holding the convertible bond for a long time.
Here’s how it works: Investors begin by shorting MicroStrategy stock in proportion to the convertible note’s “delta.” This is a measure of the sensitivity of a bond’s price to changes in stock prices. (The rate of change in delta relative to the underlying asset (in this case, the stock price) is known as “gamma”.)
Suppose you purchase a $1,000 convertible bond and the delta is 0.5. In other words, you sell $500 of stock short.
As stock prices rise and the convertible bond gets closer to being “in the money,” the delta of the bond increases and you sell more shares to stay neutral. When delta reaches 1, you will be short on the same number of shares as you expect to receive from the convertible bond. Conversely, if the stock price falls and the convertible is sufficiently “out of the money,” delta will decrease and you will buy back the stock and reduce your short position. Continuous rebalancing allows you to profit from stock volatility, regardless of its overall direction.
Think of it like harnessing wind energy. As long as there is wind, the turbine will rotate regardless of its direction. The important factor is not the direction of the wind, but the presence and speed of the wind. For traders, volatility is the wind that drives their strategies. When it comes to MicroStrategy, the company’s stock lends itself well to this type of transaction. It is volatile, liquid, and relatively easy to borrow for short sales.
Now, before you think of trying this at home, stop there. Gamma trading strategy is not for amateurs. It is complex, requires regular rebalancing, and models, broker relationships, and trading infrastructure are best left to the professionals. For tinkerers, potters and other non-experts, it’s like watching a fire-breathing performance on the beach in Zanzibar. It’s dazzling to watch and looks like anyone can do it, but attempting it without proper training can result in severe burns.
Of course, flashy financial strategies come with risks. Once stocks settle down, these volatility-based arbitrage opportunities disappear, potentially leaving Gamma Trading’s wind turbines sitting idle. (This can occur, for example, because investors in convertible bonds reduce volatility by selling shares when prices rise and buying shares when prices fall. )
For whatever reason, MicroStrategy’s volatility has subsided in recent weeks, and while it pales in comparison to the huge gains enjoyed by earlier convertibles, some investors are likely sitting on losses.
Another immediate risk is that MicroStrategy’s past five convertible bonds (currently at fairly high conversion prices between $143.25 and $232.72) may cause the price of Bitcoin (and, by extension, MicroStrategy’s stock price) to If it falls sharply, there is a possibility that it will not be converted in the end. So what happens? If the tide turns and the bond principal matures, how will MicroStrategy manage up to $6.2 billion in bond repayments?
The company’s choices will be tough. The loss-making software business generates no cash, and a treasure trove of 402,100 Bitcoins, currently valued at $39 billion, will be of little consolation. Selling Bitcoin to raise cash would probably be a last resort, but by then the price of Bitcoin would have probably fallen significantly, made worse by the effects of the sale itself. While convertible bond holders have a priority claim to these Bitcoin assets over shareholders in the event of bankruptcy, the actual “coverage” may prove to be much thinner than it appears.
Also, don’t assume that the stock price cannot fall below the conversion price. As recently as three months ago, the stock was trading below $130. For context, the spot price value of MicroStrategy’s Bitcoin holdings is equivalent to $166 per share. Until February 2024, the stock traded roughly in line with Bitcoin’s net asset value (NAV). Only the high premiums to NAV can keep most of these convertibles so comfortable.
In any case, mitigating this credit risk is not easy for investors.
One approach is to maintain a short position even if the convertible is well out of the money to avoid the possibility (or potential) of the company’s creditworthiness declining along with its stock price. However, this poses its own challenges. Instead of buying into a falling market (similar to gamma trading), investors may end up selling stocks when prices are falling. Depending on size and liquidity, selling on weakness risks being self-defeating. It’s not an easy trade to execute.
Nevertheless, so far this strategy has worked wonders. MicroStrategy created a seemingly self-perpetuating loop by exploiting stock price volatility. In other words, cheap money buys Bitcoin, which drives up stock price volatility and secures even more favorable bond terms to buy more Bitcoin. What about investors? They may or may not be Bitcoin believers or Sailor groupies. Many are simply riding the waves for the thrill of it. As long as stocks keep zigzagging, the show continues. However, as with any wire action, there is always a risk of falling.
Read more:
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