The genius of the Microstrategy trade — Convertible Bond Arbitrage
Seems like the resident Bitcoin maxi is at it again.
Microstrategy has been in the news lately, with its stock price functioning as a leveraged proxy of Bitcoin.
With the parabolic rise in Bitcoin, MSTR has been on an absolute tear this year too.
And now, we have Michael Saylor doubling down even further by raising cash through debt issuance to buy even more BTC.
At first glance, this looks like a house of cards waiting to topple.
With BTC having risen by such a crazy amount, there are well founded fears that the party may be ending soon and a crash is on the horizon.
Buying such a volatile asset on leverage is an absolute disaster waiting to happen.
Or is it?
What is a Convertible Bond ?
In order to understand the trade, we first need to wrap our heads around the notion of a Convertible Bond and why would anyone buy one. There are 2 components to this:
Zero Coupon
Most of us should be familiar with the most boring investment in the book.
US Treasuries.
These instruments give us a fixed coupon payment for each year we hold the bond.
If a treasury gives us a fixed yield of 3% per annum, that means we get $3 for each year we lock up $100 with the issuer.
For a zero coupon bond, we get $0.
Which means we simply lock up our cash with the issuer for the agreed duration and get nothing in return.
Now, that doesn’t seem like a good deal doesn’t it?
Why would anybody lock their cash away in exchange for nothing??
This brings us to the next aspect.
Convertibility
The upside of owning a convertible bond is: If the company’s stock price rises beyond a certain pre-determined amount the bond is convertible to a certain number of shares.
In their issuance, the terms are: 1.4872 shares/ $1,000 principal amount of notes expiring in 2029.
This works out to a conversion price of $672/share.
Conceptually, this bond now behaves similar manner to a $672 strike call.
If you were to purchase calls on MSTR stock, there is a risk of these calls expiring out of the money and the buyer losing the premiums paid.
In the case of the convertible bond, you get your money back.
Like how you receive the principle amount when a bond hits maturity.
Think of it as purchasing a lottery ticket, with a money back guarantee if you don’t win.
While anybody can purchase a lottery ticket and hope to receive life changing wealth, it doesn’t seem like a rigorous investment tool by any means.
The Arbitrage trade
The addition of the second leg of the trade, is where the magic happens.
To hedge the downside of the convertible bond, MSTR stock is shorted.
The resulting short stock + bond will resemble a long Put.
In the event that the BTC bubble bursts and its price crashes, MSTR stock will likely crash hard in tandem.
The second leg of this trade is designed to profit from this exact scenario.
Putting both legs together, we see that the total position resembles either
> a ratio spread
or
> a long straddle
depending on the number of shares shorted.
3 potential Scenarios
Bullish
- BTC to the moon
This is the easiest to fathom, with the price of MSTR moving in lockstep with BTC. If the shares zoom past $672 by 2029, shares can be redeemed and sold.
2. BTC increases only slightly.
Roll the bond by selling it on the secondary market, and purchasing newly issued bonds with longer dated maturity.
Bearish
3. BTC crashes.
Money back from the bond.
Collect profit on the short.
As the article here puts it, the secret sauce here is not the infinite money glitch that is BTC going to the moon.
It is the chance to make a decent profit regardless of which direction BTC goes.
If you’ve made it til there, thank you for patronage!
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