The Allure and Trap of 11.5%: Can STRC rebound to $100? What should Strategy do?

Source: Farside Investor; Compilation: Golden Finance Claw

Before discussing other issues, let's first clarify the most critical point: STRC's so-called price stabilization mechanism.

This dividend-paying product was issued at $100 and comes with a set of stabilization mechanisms designed to push the price back to $100. The logic is: if STRC trades below $100, the dividend payment increases, theoretically pushing the price up; conversely, if STRC trades above $100, the dividend amount decreases, theoretically pulling the price down. The key is to understand that this design is fundamentally unstable. If investors believe the company's credit risk is rising, STRC's price should fall, and then the company would need to raise the dividend rate, which could further deteriorate its creditworthiness, ultimately leading to a downward "death spiral."

Another point to note is that this coupon is determined at the company's discretion, not an automatic stabilization system. This option held by Strategy is unusual and introduces considerable uncertainty for investors evaluating STRC. This option creates a dilemma and legal ambiguity, making it a problem. In our view, this issue requires a long-term solution.

Before considering other key questions, it's crucial to understand this potential instability and uncertainty. Those questions include:

• Can MSTR afford the dividends?

• Should one invest in STRC?

• Will STRC return to par value?

• What should Strategy do now?

Should one borrow at 11.5% to buy Bitcoin?

Before considering STRC, it's worth trying to look at this deal through basic financial logic. MSTR issued this perpetual debt instrument with a coupon rate of 11.5%, received $100, and used those proceeds to buy Bitcoin. Even though this debt is perpetual and never needs to be repaid, in our view, on the surface, it's a bad deal. If someone offered us a perpetual loan at an annual rate of 11.5% to buy Bitcoin, we would refuse. This rate, 11.5%, is simply too high.

For example, Bitcoin might appreciate at an average rate of 10% per year. Long-term inflation might be 5%. Even then, Bitcoin could be considered a huge success and might even be heading toward "Bitcoinization," but it still wouldn't achieve an annual growth rate of 11.5%. Therefore, issuing this perpetual instrument will negatively impact the issuer's balance sheet over the long term.

Moreover, Bitcoin's price doesn't rise in a straight line. Over the long term, Bitcoin's price might appreciate by more than 11.5% on average, but there will also be periods of decline. To pay interest, one might need to sell Bitcoin when its price is low. This could also result in net losses for the issuer, even if the debt never needs to be repaid.

We created a very basic "STRC Fair Value Calculator" tool, which can be found here: https://farside.co.uk/strc/

Assuming an 8% discount rate and stable dividend payments at 11.5%, this tool calculates STRC's value at $144, well above the $100 issue price.

Therefore, in our view, if we assume the coupon is stable at 11.5%, or that this 11.5% is the issuer's obligation (which it is not), then issuing STRC is a very bad deal. In contrast, investing in STRC might be a good investment. In short, we believe no one should borrow at 11.5% to buy Bitcoin; it's a very bad deal.

So, should one borrow at 11.5%, but with the right to gradually reduce the rate to SOFR (Secured Overnight Financing Rate), to buy Bitcoin?

STRC is much more complex than a fixed-rate 11.5% perpetual bond. It has a price stabilization mechanism, and MSTR can adjust the coupon rate at its discretion. Although the company seems to have indicated it will use this discretion to target $100, based on the issuance documents, the company appears to have no obligation to do so. The company has the right to reduce the coupon by 25 basis points each month until it reaches the SOFR rate (currently about 3.6%). The company faces no penalty for doing so.

Using the Farside calculator again, when factoring this in and calculating the net present value of future cash flows, we value this instrument at $55.

$55 is far below $100. Therefore, borrowing on these terms to buy Bitcoin is an excellent deal for the borrower and a bad deal for the lender (investor).

Inherent Contradiction

STRC's issue price is neither $55 nor $144, but $100. Therefore, this price itself incorporates significant uncertainty surrounding the price stabilization mechanism and the future direction of coupon payments.

STRC is a product full of contradictions. It is a novel and peculiar product that can be viewed from multiple angles.

The price stabilization mechanism has already failed. STRC trades at around $75, 25% below the $100 target. The company has not responded by raising the coupon, likely due to fear of a downward death spiral or because they already consider 11.5% high enough. Indeed, assuming a reasonable discount rate and the company remains solvent, under a fixed 11.5% coupon, this instrument should trade not at $100, but well above $100.

However, this does mean the price stabilization mechanism is largely ineffective. It may not be 100% failed, as the company can argue the mechanism has a cap. That is, the company might raise the coupon to try to return to $100, but only if the yield is below 11.5%. Of course, as we recall, the company did not explain this in advance. If this is the case, i.e., 11.5% is the top of the rate range, then it further suggests that issuing the product at this rate was too high. Certainly, if the rate has a cap, the company should only issue new STRC when there is a significant buffer (e.g., at least 2%) between the cap and the current rate.

Regardless, the price stabilization mechanism now appears largely defunct. In our view, this means there is no particular reason to believe the product will return to $100. With the price stabilization mechanism broken and no redemption mechanism, the $100 price holds no special significance in the future. Those claiming the instrument will return to this price may be overly optimistic.

Another potential consequence of the failed price stabilization mechanism is that it increases uncertainty about future coupon policy. Since it has already failed, this could become an argument for reducing the coupon by 25 basis points each month until reaching the SOFR rate. If the market expects MSTR to do this, then as noted above, STRC should trade around $55. Doing so would also solve two other problems. First, in our view, the company's coupon payments would become quite affordable, and concerns about their cash flow issues should disappear. Another problem, the inherent instability of the price stabilization mechanism that the company may be reluctant to acknowledge, would also vanish as this unstable mechanism is completely abandoned.

What Should MSTR Do Now?

In the short term, the simplest and most likely option is to do nothing. The company can keep the coupon at 11.5% and not worry about the fact that the instrument trades well below $100. The company can try to finance coupon payments for as long as possible by issuing new stock or selling Bitcoin, even if Bitcoin prices are well below the average purchase price, or if the stock trades at a steep discount to mNAV (market value adjusted net asset value). The trouble with this approach is that it's essentially buying time. The company claims it now has a large cash buffer, but once that money is gone, we return to the state with no buffer. The problem is that for a $10.5 billion issued product, an 11.5% interest rate represents a huge cash drain relative to the current balance sheet size. STRC has an inherently unstable price stabilization mechanism and massive uncertainty about the direction of coupon policy. Resolving this uncertainty now and fixing the problem as soon as possible might be the best course for the company and Bitcoin. However, taking the path of least resistance, not admitting fault, and allowing the plan to continue as long as one can get away with it is tempting.

Before discussing how to solve the problem, there might be one more thing the company could try. The company could simply announce a reduction in the coupon without providing a clear policy or guidance. MSTR could state that the 11.5% rate is simply too high, but they want to be fair to investors, so they will target a more moderate rate, say around 8%. Such a rate would be more affordable for the company and fairer to investors, who could avoid seeing their investment drop to around $55. This arrangement might be reached through discussions between the company and STRC holders. However, without legal enforcement, this would leave potential uncertainty about long-term coupons.

If the company truly wants to resolve the issue completely, in our view, there are actually two realistic options:

1. Start repurchasing STRC

2. Abandon the price stabilization mechanism entirely and lower the rate to SOFR

In the long run, we believe the company will eventually go down one of these paths, or first buy back some shares and then eventually lower the coupon to the SOFR rate if unable to repurchase all outstanding shares.

It might be challenging for the company to justify repurchasing STRC right now, as it was just issued, and doing so would represent a policy reversal. Additionally, buybacks could raise legal questions. Since the bond price is heavily influenced by market perceptions of coupon policy and signals from the company—which the company can control simply by signaling without taking any action—one could argue that the company buying back at a discount might be somewhat unfair. However, no matter which path the company chooses, it may face legal challenges, such as the AI bikini girl ad (the image at the top of this article) leaving vulnerabilities. In this case, buybacks might be the best way out, with a repurchase price based on the company's ability to raise funds by selling Bitcoin or issuing stock, and set at a level that strikes a compromise between reducing legal risk and enhancing shareholder value.

Currently, market speculation about possible buybacks may be supporting the price, keeping the instrument trading well above $55. We believe a buyback is the most likely outcome. It may just take some time until the company eventually succumbs to pressure and faces reality.

Disclosure: Farside Equity Funds hold no positions in MSTR or STRC. The content of this article should not be used as a basis for investment decisions nor construed as advice to engage in any investment transaction.