Convertible Arbitrage and MicroStrategy
Ask A CIO #32
Can you explain what’s happening with MicroStrategy? How is it able to issue so much debt, and who’s buying it?
While I haven’t spent a ton of time thinking about MicroStrategy, I’ll share what I think is a reasonable overview from a capital markets perspective. And I have to confess – I do find the whole thing fascinating.
Before I go any further, I want to first caveat that absolutely nothing I’m about to write constitutes an endorsement of MicroStrategy or any securities associated with the company. Like, at all.1 But regardless of how anyone might feel about the company or company-related investments, it’s an undeniably interesting example of capital market creativity.
Just to be clear, this is not about to be an exercise in analyzing MicroStrategy’s capital structure or a debate on the value of Bitcoin. I have no particular interest in the former and no particular expertise on the latter, and there are plenty of armchair analyses on these points elsewhere across the internet. I’m going to take this question at its face value – literally, why is this MicroStrategy phenomenon happening?2
As I organize my thoughts here, let me lay out what I think are the three groups of characters in this story: the buyers of the company’s stock, the buyers of the company’s convertible notes, and the company itself.
Starting with the company itself is probably the easiest. MicroStrategy is a real operating business – it sells software services. For a long time, that was pretty much all that it did. In the course of operating its software business, MicroStrategy generated extra cash, which was then held on the company balance sheet. MicroStrategy held this excess cash, also known as company treasury holdings, in short-term investments, like Treasury bills. All normal company things.
At some point in 2020, MicroStrategy declared that instead of keeping its corporate treasury holdings in cash or Treasury bills, the company would instead buy Bitcoin. MicroStrategy has since raised cash, primarily by selling convertible bonds, to add to its treasury holdings, which again, are now all Bitcoin. So MicroStrategy basically raises cash to buy more Bitcoin. And that’s where the company finds itself today – it technically has an operating business, but it can be (and often is) considered a Bitcoin holding company.
Let’s move to the buyers of the company’s convertible bonds. Notably, MicroStrategy only began issuing convertible bonds after it adopted its Bitcoin treasury strategy. Here, I’ll take a short detour to briefly describe convertible bonds.
Convertible bonds are hybrid securities. They are bonds, and like regular (“straight”) bonds, are issued with a yield and maturity date. But convertibles also have a special feature that gives the owners of the bonds the right to convert their bonds into company stock under specific circumstances – namely when the stock of the company trades above a specified price, also known as the conversion price. This conversion price is determined when the bond is issued and is typically significantly higher than the company’s stock price at the time of issuance.
There are other nuances, but basically, convertible bonds are corporate bonds that come with an embedded warrant (or out of the money call option). Because convertible bonds have the potential to capture equity upside, companies can often issue convertibles at lower yields than if they were to issue straight bonds. In the case of MicroStrategy, where the market saw potential for significant equity upside, the company has been able to issue convertible notes with 0% yield. In other words, the company could borrow at 0% to buy Bitcoin.
There are typically two groups of convertible bond buyers. There are long-only investors, who invest long-only in convertible bonds and seek to generate equity-like upside returns with bond-like downside protection.
And then there are convertible arbitrage investors. These investors pair long investments in a company’s convertible bond with short positions in the company’s stock.
Because convertible bonds have that embedded option feature, convertible bond prices are sensitive to their underlying company stock price. Convertible arbitrage investors take short positions in the company’s stock to hedge out that sensitivity. That sensitivity – how much the convertible bond price changes with the stock price – also fluctuates depending on the stock price. So convertible arbitrage investors are constantly changing their stock positions.
Assuming the convertible bond is out of the money on the call option (the company’s stock price is below the conversion price), the convertible arbitrage investor experiences the following:
If the stock price goes up, the embedded call option is closer to being in the money, and so the convertible bond price becomes more sensitive to the stock price. Because the sensitivity went up, the convertible arbitrage investor shorts more stock (i.e., sells stock).
If the stock price goes down, the embedded call option is now farther from being in the money, and so the convertible bond price is less sensitive to the stock price. The convertible arbitrage investor can reduce the short stock position (i.e., buys stock).
This constant hedging results in a dynamic where the convertible arbitrage investor is buying stock when the stock goes down and selling stock when the stock appreciates. Buy low and sell high is usually a good recipe for making money.
Given the above dynamic, you can see why convertible arbitrage investors might favor convertible bonds in companies with volatile stock prices.3 In the case of MicroStrategy, where the stock is perceived as a Bitcoin holding company, and Bitcoin is notoriously volatile, convertible arbitrage investors understandably expect high volatility in MicroStrategy’s stock price.
Last, but certainly not least, are the investors buying MicroStrategy stock. Contrary to what you might picture as the shareholder base for meme stocks, the investor base for MicroStrategy stock in fact includes a large percentage of institutional shareholders.
Why do institutional funds hold MicroStrategy? I assume for the same reason as individual shareholders – exposure to Bitcoin. But unlike individual investors, some institutional shareholders are restricted from holding Bitcoin directly. Some funds are also restricted from holding Bitcoin ETFs. By virtue of being a publicly traded company, and it is still considered a company, MicroStrategy is, however, a permitted holding.
And so, for all the ways in which the ecosystem around MicroStrategy looks irrational, there are other viewpoints through which it almost all makes sense. Where if you squint enough, it might look more like capital market ingenuity versus pure speculation.4
Of course, all the participants in this MicroStrategy ecosystem presumably have some opinion on the value of Bitcoin. Even the convertible arbitrage investors who are hedging their exposure have to believe that the convertible bonds are covered by the company’s assets (again, primarily Bitcoin) because convertible bonds are still bonds. And on that note, I think I’ll end this week’s newsletter here.
Thanks for reading, and as always, please reach out: askacio@ivyinvest.co!
Until next week,
Wendy
The Institutional Investment Strategy Fund does not hold a position in MicroStrategy.
Yes, there’s a clear meme stock aspect to MicroStrategy, but I think to dismiss it outright so flippantly disregards a lot of legitimate reasons for why various participants are engaging with the company and its related securities.
Again, there are a lot of other nuances to convertible arb strategies, but stock price volatility is generally positive for the strategy.
MicroStrategy is apparently preparing to issue perpetual preferred stock, which again, just fascinating. Perpetual preferreds are typically issued by financial institutions – banks, insurance companies, etc. I can’t recall the last time I heard about a non-financial company issuing this type of security.