Interpreting MicroStrategy's Strategy: An In-Depth Exploration of Crypto-Supported Convertible Bonds (Part 1)
Cryptocurrency-backed convertible bonds provide multiple incentives for investors. As a debt instrument, they offer downside protection through regular interest payments, thereby reducing exposure to the inherent volatility of cryptocurrencies.Author: Aquarius
Original link:
Convertible Bonds
Convertible bonds are a hybrid financial product that combines features of debt and equity. The issuer raises funds by selling bonds, providing regular interest payments and a fixed maturity date, while investors have the option to convert the bonds into shares at a predetermined conversion rate.
In recent years, the convertible bond market has experienced significant growth. This year's convertible debt issuance is expected to reach $70 billion to $80 billion, a 40% increase from 2023. Cryptocurrency trading has become one of the main drivers of convertible bond activity in 2024. For example, Boeing completed the largest single equity-linked transaction of the year by issuing $5.75 billion in mandatory convertible preferred stock as part of its strengthening balance sheet. Meanwhile, MicroStrategy raised $6.2 billion through the issuance of convertible bonds, inspiring other companies to adopt its strategy of purchasing Bitcoin.
Issuers in the cryptocurrency space are offering particularly attractive terms, with some bonds even having zero coupon rates. Citigroup's Duffield notes that these favorable terms stem from increased volatility in the stock market and benchmark indices nearing or reaching historical highs.
Cryptocurrency-Backed Convertible Bonds
Cryptocurrency-backed convertible bonds are increasingly favored by publicly listed companies looking to raise funds while harnessing the potential of digital assets. By combining debt with equity conversion options, cryptocurrency-backed convertible bonds attract issuers and investors seeking to balance risk and return. Unlike traditional convertible bonds, these instruments extend their utility by using proceeds for cryptocurrency-related activities such as purchasing digital assets, expanding mining operations, and advancing blockchain-based services.
Cryptocurrency-backed convertible bonds provide multiple incentives for investors. As debt instruments, they offer downside protection through regular interest payments, thereby reducing exposure to the inherent volatility of cryptocurrencies. At the same time, the equity conversion option allows investors to benefit from potential stock price increases driven by the issuer's successful cryptocurrency strategy. This dual attribute makes them an attractive choice for investors seeking income and growth opportunities.
The adoption of cryptocurrency-backed convertible bonds has grown significantly, with several leading companies raising substantial funds through such instruments. For instance, MARA Holdings issued $2.2 billion in zero-coupon bonds to fund Bitcoin purchases and expand mining operations. From 2020 to 2024, the total funds raised through these bonds exceeded $15 billion globally. The average coupon rate for these bonds ranges from 0.5% to 3%, significantly lower than traditional corporate debt, reflecting the added value brought by the equity conversion option.
Despite their advantages, cryptocurrency-backed convertible bonds also carry inherent risks. The volatility of the cryptocurrency market can significantly impact the value of the acquired assets and the performance of the issuer's stock. For example, MicroStrategy's stock fell by 40% during the 2022 bear market due to a decline in Bitcoin prices. Additionally, regulatory uncertainty poses challenges, especially for mining companies scrutinized for energy consumption and environmental impact. Furthermore, the success of these bonds largely depends on the issuer's ability to execute its cryptocurrency strategy. Poor management or operational inefficiencies may undermine investor confidence and returns. Lastly, the conversion of debt to equity may dilute existing shareholders' interests, potentially leading to a decrease in stock price.
Current Market Conditions
MicroStrategy remains the largest issuer of convertible bonds, raising over $6 billion for its Bitcoin acquisition strategy.
Under the leadership of Michael Saylor, MicroStrategy has pioneered the use of convertible debt to treat Bitcoin as a treasury reserve asset. By offering low-interest debt, MicroStrategy has capitalized on strong institutional and retail demand, using the proceeds to purchase Bitcoin. As of the end of 2024, the company holds 423,650 Bitcoins, valued at over $41.5 billion, accounting for approximately 2% of the total Bitcoin supply. This aggressive strategy not only solidified MicroStrategy's financial position but also inspired other companies to follow suit, setting a precedent for corporate capital allocation in the cryptocurrency space.
Coinbase and Block Inc. follow closely, each raising over $2 billion, focusing on operational growth and integration within the Bitcoin ecosystem.
Block Inc. (formerly Square Inc.) is a financial services company that has supported its Bitcoin-related initiatives and blockchain integration through three convertible bond issuances totaling $3.65 billion. These bonds include a 0.125% convertible senior bond maturing in 2025, a 0.25% convertible senior bond maturing in 2026, and a 0.50% convertible senior bond maturing in 2027, with proceeds allocated to expanding its Bitcoin ecosystem through Cash App, merchant solutions, and Bitcoin custody services. Additionally, Block holds approximately 8,000 Bitcoins, reflecting its commitment to adopting Bitcoin as a corporate strategy. The company also invests in open-source blockchain projects, such as decentralized Bitcoin mining, to advance its mission of making Bitcoin more accessible. Despite its unique innovative approach, Block faces challenges from cryptocurrency market volatility and regulatory pressures.
Mining-focused companies like MARA Holdings, Riot Platforms, and Terawulf leverage convertible bonds to expand operations and purchase Bitcoin, capitalizing on mining profitability.
MARA Holdings Inc. is a leading cryptocurrency mining company that raised $2.2 billion through the sale of convertible bonds, establishing a significant position in the market. The company strategically uses the proceeds to expand its mining operations, acquire more Bitcoin, and manage debt obligations. MARA holds approximately 12,000 Bitcoins, demonstrating its commitment to treating Bitcoin as a treasury asset. However, the company faces challenges from Bitcoin price volatility and regulatory scrutiny, which could impact its profitability and operational stability.
Riot Platforms Inc. is a leading Bitcoin mining company that issued $500 million in convertible bonds, with an additional $75 million option, to fund its operations and Bitcoin acquisition strategy. The proceeds from this issuance are allocated to purchasing mining hardware, expanding infrastructure, and acquiring Bitcoin to enhance its balance sheet. As of the end of 2024, Riot holds approximately 11,425 Bitcoins, emphasizing its commitment to expanding mining capacity and utilizing Bitcoin as a strategic reserve asset. By focusing on operational expansion, Riot aims to improve profitability and enhance its competitiveness in the cryptocurrency mining sector. However, its success largely depends on the stability of Bitcoin prices, energy costs, and the regulatory framework affecting mining operations.
Terawulf Inc. stands out in the market by combining cryptocurrency mining with sustainable practices. The company financed $500 million in convertible debt to integrate renewable energy into its mining operations. This approach not only addresses growing environmental concerns but also attracts investors seeking eco-friendly investment opportunities. Terawulf's strategy positions it as a leader in sustainable mining, providing a competitive advantage in a market often criticized for its environmental impact.
WisdomTree and Strive Asset Management showcase the growing interest in cryptocurrency-related financial products, focusing on ETFs and tokenized investments.
WisdomTree Inc. is a well-known asset management company that has driven its expansion in the cryptocurrency and blockchain space through convertible bonds. The company issued two key bonds: a 3.25% convertible senior bond maturing in 2023, raising $150 million, and a 5.75% convertible senior bond maturing in 2028, raising another $150 million. These bonds fund WisdomTree's innovations, supporting its cryptocurrency-focused exchange-traded funds (ETFs) and blockchain-based investment products, providing regulated exposure to digital assets for traditional investors. By integrating blockchain technology, WisdomTree aims to tokenize traditional assets and enhance efficiency, establishing its leadership in the cryptocurrency financial products space. However, its success depends on navigating regulatory challenges and market volatility, which remain key risks in its strategic expansion.
Strive Asset Management has proposed an innovative strategy to launch a Bitcoin-backed ETF by utilizing convertible bonds issued by companies like MicroStrategy, which use the proceeds to purchase Bitcoin. This ETF aims to provide institutional and retail investors with indirect exposure to Bitcoin through regulated financial products, avoiding the complexities of directly holding cryptocurrencies. Strive's approach highlights the bridge between traditional finance and digital finance—the growing demand for cryptocurrency-related investment tools. By investing in convertible bonds linked to Bitcoin purchases, the ETF offers a diversified risk-return profile, appealing to cautious investors. However, Strive's success relies on obtaining regulatory approval, ensuring transparency, and maintaining robust risk management practices in the rapidly evolving cryptocurrency market.
Issuer Strategies
Companies from various industries have adopted diverse strategies to leverage convertible bonds to maximize value, control risk, and align with their specific objectives.
Accumulating Bitcoin as a Treasury Asset
One of the most notable strategies is using the proceeds from convertible bonds to accumulate Bitcoin as a treasury reserve asset. This approach, pioneered by MicroStrategy, transforms Bitcoin into a core part of the balance sheet. The company raises funds through low-interest convertible bonds and uses them to purchase Bitcoin when market conditions are favorable or prices decline. This strategy leverages Bitcoin's potential as "digital gold," providing companies with a tool to hedge against inflation and store long-term value. However, this strategy is not without risks, as companies must endure the impact of Bitcoin price volatility and may face balance sheet vulnerabilities during bear markets.
Expanding Cryptocurrency Mining Operations
Another widely adopted strategy is expanding cryptocurrency mining operations. Companies like MARA Holdings, Riot Platforms, and Core Scientific use the proceeds from convertible bonds to enhance mining infrastructure, purchase cutting-edge hardware, and boost energy capabilities. The Bitcoin generated from mining becomes a key revenue source, providing operational leverage when Bitcoin prices rise. However, this strategy comes with significant risks, including high energy costs, regulatory scrutiny, and profitability challenges during bear markets.
A noteworthy strategy is combining environmental sustainability with cryptocurrency by integrating renewable energy into mining operations. Terawulf has pioneered this approach, using proceeds from convertible bonds to develop mining infrastructure reliant on renewable energy. This strategy addresses environmental concerns surrounding Bitcoin mining while attracting environmentally conscious investors. By reducing carbon footprints and enhancing efficiency, companies like Terawulf position themselves as leaders in sustainable mining. However, high upfront capital expenditures and reliance on a continuous supply of renewable energy remain major challenges.
Diversifying Revenue Streams
Some companies have diversified their revenue sources by investing proceeds in a broader range of cryptocurrency services. For example, companies like Galaxy Digital and Coinbase allocate funds to trading, asset management, staking, and lending services. By offering a wide array of cryptocurrency-related financial products, these companies position themselves as comprehensive players in the digital asset ecosystem. This approach reduces dependence on Bitcoin prices and attracts institutional clients. However, managing diverse services requires extensive expertise and resources while navigating regulatory uncertainties in areas like staking and lending.
Hedging Market Volatility
Issuing cryptocurrency-backed convertible bonds can also serve as a tool for hedging against market volatility, attracting both equity and debt investors. These bonds allow investors to gain indirect exposure to cryptocurrencies while reducing the risks associated with direct ownership. Investors receive downside protection through regular interest payments while retaining the option to convert the bonds into equity under favorable conditions. This strategy provides issuers with a low-cost fundraising method and offers investors a balanced risk-return profile. However, during periods of high market volatility, conversion terms may become unfavorable, and stock prices may not align with the company's cryptocurrency strategy.
Bitcoin-Backed ETFs
Finally, the launch of Bitcoin-backed ETFs represents an innovative use of convertible bonds. Strive Asset Management has proposed an ETF that invests in bonds issued by companies like MicroStrategy, which use the proceeds to purchase Bitcoin. This approach enables institutional investors to gain indirect access to the cryptocurrency market through regulated financial products. While this strategy diversifies exposure to Bitcoin-backed corporate strategies, it heavily relies on the performance of the underlying bonds and faces regulatory challenges.
Investor Returns and Tax Implications
Highlights
- Tax Deferral: A key tax advantage of convertible bonds is the deferral of taxes until the bonds are sold or converted.
- Capital Gains vs. Ordinary Income: The conversion of bonds itself is not a taxable event, but subsequent sales are subject to capital gains tax, while interest income is taxed as ordinary income.
- Special Cases (OID/Dividends): Original Issue Discount (OID) and dividends have different tax treatments, with OID taxed as ordinary income, while dividends may qualify for lower tax rates.
- Cryptocurrency Exposure: Cryptocurrency-backed convertible bonds provide the same tax deferral benefits as traditional convertible bonds while increasing protection against market volatility.
Cryptocurrency-backed convertible bonds offer unique tax advantages compared to direct ownership of cryptocurrencies, making them highly attractive to both investors and issuers. These financial instruments allow investors to defer taxable events and strategically plan tax liabilities while providing issuers with opportunities to raise funds at a lower cost.
Under U.S. tax law, convertible bonds are treated as debt instruments, and investors must report interest income on their annual tax returns. For example, investors holding MicroStrategy's 2027 convertible senior bonds, which are zero-coupon bonds, do not need to report interest income but must calculate capital gains or losses upon the sale or conversion of the bonds. Converting bonds into equity is typically considered a non-taxable event, allowing investors to defer taxes until the sale of the converted equity. The tax basis of the acquired equity equals the original cost of the bonds, and the holding period of the bonds can be used to qualify for long-term capital gains treatment, which is taxed at a lower rate than ordinary income.
In contrast, cryptocurrency transactions (such as selling or exchanging Bitcoin) trigger immediate capital gains or losses based on the difference between the fair market value of the asset and its purchase cost. For example, if someone buys Bitcoin for $30,000 and sells it for $60,000, the $30,000 gain will be taxed at short-term or long-term rates based on the holding period. Additionally, income generated from cryptocurrency through staking or mining is taxed as ordinary income upon receipt, establishing a new cost basis for future transactions.
Tax Deferral
Tax deferral is one of the most significant advantages of cryptocurrency-backed convertible bonds. Unlike direct ownership of cryptocurrencies, which requires reporting gains and losses for every transaction, bondholders only pay taxes on interest income until the bonds are sold or converted. For instance, if Coinbase's 0.50% convertible senior bond maturing in 2026 appreciates tenfold due to company growth or rising cryptocurrency valuations, bondholders can defer realizing taxable gains until they choose to convert or sell the bonds, even if the potential value of the bonds significantly increases.
Cryptocurrency Exposure
Moreover, cryptocurrency-backed convertible bonds provide protection against cryptocurrency market volatility. Through bonds, investors benefit from the fixed income portion and only face taxable events when interest is paid or the bonds are settled. For example, Riot Platforms' $500 million convertible bonds allow investors to receive interest income while deferring tax liabilities related to the company's increasing Bitcoin holdings (11,425 BTC as of the end of 2024).
In terms of compliance, the IRS requires reporting all interest income from convertible bonds through Form 1099-INT and Schedule B. Capital gains or losses from the sale or conversion of bonds must be reported through Schedule D and Form 8949. In contrast, cryptocurrency transactions are subject to stricter regulations, requiring detailed records for each sale, exchange, or transfer, reported through Form 8949. Inaccurate reporting of cryptocurrency transactions may lead to penalties, and the IRS is increasingly auditing cryptocurrency investors.
Growing Popularity
In practical cases, the tax deferral advantages of convertible bonds reflect their growing popularity among investors seeking to minimize taxable events while gaining exposure to the cryptocurrency market. For example, MicroStrategy's issuance of $6.16 billion in convertible bonds allowed investors to avoid immediate capital gains taxes that would have been incurred from directly holding Bitcoin. Similarly, Coinbase's convertible bonds provide investors with exposure not only to the company's performance but also to the broader cryptocurrency market without the immediate tax burden associated with direct digital asset trading.
In conclusion, cryptocurrency-backed convertible bonds present an appealing option for investors looking to optimize tax strategies while gaining exposure to digital assets. These instruments offer an effective way to balance risk and return in the evolving cryptocurrency market by deferring taxable events and providing strategic conversion opportunities. However, investors must remain vigilant about compliance requirements and consult tax professionals to navigate the complexities of these instruments.
Disclaimer: This article is for general informational purposes only and does not constitute investment advice, a recommendation, or an invitation to buy or sell any securities. It should not be the basis for making any investment decisions, nor should it be relied upon as accounting, legal, tax, or investment advice. You are advised to consult your own advisors regarding legal, business, tax, or other matters related to any investment decision. Some of the information contained in this article may come from third-party sources, including portfolio companies of funds managed by Aquarius. The views expressed in this article are solely those of the author and do not necessarily reflect the views of Aquarius or its affiliates. These views are subject to change at any time and may not be updated in a timely manner.
