What are priority convertible bonds?
Priority convertible bonds are a type of debt instrument (loan) that you (as an investor) can convert into common stock of the issuing company. But you may be wondering, what does "priority" mean here?
The term "priority" means that if the company goes bankrupt, the holders of these bonds will be given priority in debt repayment compared to other creditors (such as those holding subordinate bonds or unsecured debt).
Here are some important terms related to priority convertible bonds that you need to understand:
- Principal amount: The initial amount of money the company borrowed.
- Interest rate: The fixed or variable rate of interest calculated on the principal.
- Maturity date: The date the company must repay the principal.
- Conversion price: The predetermined stock price at which the bonds can be converted into common shares.
- Conversion ratio: The number of common shares each bond can be converted into.
Why would a company issue priority convertible bonds?
There are several reasons why a company may choose this form of financing, including:
- Flexible funding: This instrument allows the company to raise capital, especially in the early stages or during periods of instability.
- Avoiding dilution: Unlike traditional equity financing (selling shares), convertible bonds do not immediately dilute the ownership of existing shareholders.
- Tax benefits: In some cases, the interest payments on convertible bonds may be tax-deductible for the company.
So, why would an investor buy priority convertible bonds?
Holders of priority convertible bonds can participate in the company's growth by converting into shares, making it more attractive than traditional debt. As a fixed-income instrument with a clear maturity date, convertible bonds also provide some protection against downside risks for investors.
How convertible bonds work in Bitcoin investment
MicroStrategy is a prominent example of using convertible bonds to raise capital to buy Bit. Here's a simple explanation of how they work in this context:
- Company issues bonds: A company operating in the Bit mining or Bit-related business may issue convertible bonds to raise capital.
- Investors buy bonds: Investors purchase these bonds, effectively lending money to the company.
- Interest and conversion rights: The bonds typically come with a fixed interest rate and maturity date. They also give the investor the right to convert the bonds into the company's stock at a predetermined conversion price.
- Correlation with Bit: If the company's business model is closely tied to Bit, the value of the company's stock may fluctuate with the price of Bit.
- Growth potential: If the price of Bit increases and the company operates effectively, the value of the company's stock may rise significantly, providing a substantial return for investors when they convert the bonds into shares.
- Risk protection: Convertible bonds are debt instruments, providing a certain level of protection. If the company fails, investors may still be able to recover their principal investment (depending on the company's financial situation).
How MicroStrategy uses priority convertible bonds to buy Bit
Let's explore how MicroStrategy has used priority convertible bonds to buy Bit:
- Issuing convertible bonds: The company has undertaken multiple rounds of issuing priority convertible bonds to raise capital. These bonds typically have a fixed maturity date and a 0% coupon structure, meaning they do not pay periodic interest. MicroStrategy began its Bit strategy in 2020 with a $250 million Bit purchase using cash. Since then, the company has raised over $3 billion through convertible bond offerings to continue acquiring Bit.
- Using the proceeds to buy Bit: The funds raised from the bonds have primarily been used to purchase Bit, significantly increasing the amount of Bit held by MicroStrategy. As of December 3, 2024, the company owns approximately 402,100 BTC (equivalent to 1,915% of the total 21 million BTC supply).
- Leveraging the potential of Bit: By heavily investing in Bit, MicroStrategy aims to capitalize on the long-term appreciation of the cryptocurrency. If the price of Bit increases, the value of the Bit holdings will also rise, potentially driving up the stock price of MicroStrategy (MSTR).
On November 20, 2024, MicroStrategy announced the issuance of $2.6 billion in priority convertible bonds, maturing in 2029. The key points include:
- 0% coupon structure: The bonds do not pay periodic interest.
- Conversion rights: Bondholders can convert the bonds into MicroStrategy's common stock at a conversion price of $672.40 per share.
- Maturity date: December 2029.
- Call option: MicroStrategy has the right to redeem the bonds starting in December 2026 if the company's stock price reaches 130% of the conversion price for a certain period. Upon redemption, investors receive 100% of the principal plus accrued interest. Other factors may also influence the redemption decision.
This strategy has delivered an annual return of 80% for MicroStrategy from 2020 to 2024, outperforming even Bit. Since mid-2020, MicroStrategy has outperformed all major U.S. stocks, including Nvidia, thanks to its Bit accumulation strategy.
The company's stock has risen more than 2,500% since August 2020, while the price of Bit has only increased 660% during the same period. This performance demonstrates the significant impact of Bit's price appreciation on the success of MicroStrategy in the market.
However, investors need to be aware that the company's strategy carries high risk and high volatility due to its heavy reliance on the long-term growth potential of Bit.
Benefits of Preferred Convertible Bonds
For companies like MicroStrategy, preferred convertible bonds offer the following benefits:
- Reduced borrowing costs: The 0% (zero-coupon) interest rate structure helps the company avoid paying periodic interest, thereby reducing its financial expenses.
- Lower issuance costs: Compared to traditional debt or equity issuance, preferred convertible bonds typically require lower upfront costs. This is particularly evident when compared to issuing regular debt or raising equity capital, which often involve a complex underwriting process (due diligence, pricing, and accepting the risk of a new securities offering) and higher associated fees.
- Flexible capital raising: This instrument provides a flexible way to raise capital without immediately diluting the equity of existing shareholders.
- Attracting investors: Convertible bonds can be appealing to investors who want exposure to both the company's core business and an investment in Bit.
Risks Associated with Preferred Convertible Bonds
The following are some of the potential risks to consider:
- Bit price volatility: The value of the Bit holdings of MicroStrategy can be significantly affected by price fluctuations, which can impact the company's financial performance.
- Regulatory uncertainty: The regulatory environment for cryptocurrencies is constantly evolving and may introduce additional risks for the company.
- Conversion risk: If the MSTR stock price falls below the conversion price, investors may not be willing to convert the bonds into shares, which could lead to dilution of existing shareholders.
- Market timing and hedging risks: MicroStrategy is betting on the long-term appreciation of Bit - i.e., assuming a positive market outlook. If Bit faces a prolonged market downturn, this strategy could backfire, as the company will have to bear significant debt obligations and the value of its Bit assets may decline.
- Rising interest rates: Borrowing costs - especially in a rising interest rate environment - can add further pressure on companies issuing hybrid financial instruments. Increasing interest rates raise the cost of servicing debt, creating additional financial burdens for companies using this strategy.
Overall, the sustainability of MicroStrategy's bold strategy of using preferred convertible bonds to finance Bit purchases depends on fundamental financial principles and the broader economic context.
The risks are particularly pronounced for investors who do not fully understand or agree with the rationale for holding a highly volatile asset like Bit on the balance sheet. To ensure long-term sustainability, companies need to take a balanced approach, combining market analysis, risk management strategies, and flexible capital planning.
