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

Source: Farside Investor; Compiled by 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 stabilization mechanism 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 pushing 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 the company's credit condition, potentially leading to a downward "death spiral."

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

Before considering other key issues, it is crucial to understand this potential instability and uncertainty. Those issues 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% interest to buy Bitcoin?

Before considering STRC, it's worth looking at this trade with basic financial logic. MSTR issued this perpetual debt instrument with a coupon rate of 11.5%, received $100, and used the proceeds to buy Bitcoin. Although this debt is perpetual and never needs to be repaid, in our view, on the surface, this is a bad trade. If someone offered us a perpetual loan at an annual interest 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 annual rate of 10%. Long-term inflation might be 5%. Even then, Bitcoin could still 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 have a negative impact on the issuer's balance sheet in the long run.

Additionally, Bitcoin's price does not go up in a straight line. Over the long term, Bitcoin's price might appreciate by more than 11.5% on average, but there could also be periods of decline. To pay interest, it might be necessary to sell Bitcoin at low prices. 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 that the dividend payment remains stable at 11.5%, this tool calculates STRC's value at $144, far above the issuance price of $100.

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

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

STRC is far more complex than a fixed-rate 11.5% perpetual bond. It has a price stabilization mechanism, and MSTR can unilaterally adjust the coupon rate. Although the company seems to have indicated it will use this discretion to target $100, based on the offering 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 around 3.6%). The company can do this without any penalty.

Using the Farside calculator again, when we factor this in and calculate 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 issuance price is neither $55 nor $144, but $100. Therefore, this price itself contains a great deal of uncertainty regarding 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 is trading at around $75, 25% below the $100 target. The company has not responded by raising the coupon, possibly because they are concerned about a downward death spiral, or because they already consider 11.5% high enough. Indeed, assuming a reasonable discount rate and that the company remains solvent, with a fixed 11.5% coupon, the instrument should not trade at $100 but far above $100.

However, this does mean the price stabilization mechanism is largely broken. It may not be 100% broken because the company could argue there is a cap on the mechanism. That is, the company might raise the coupon to attempt 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 that is the case, i.e., 11.5% is the top of the interest rate range, then this further indicates that issuing the product at this rate was simply too high. It is safe to say that if there is an interest rate cap, the company should only issue new STRC when there is ample buffer (e.g., at least 2%) between the cap and the current rate.

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

Another potential consequence of the price stabilization mechanism's failure 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 mentioned 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 problems should disappear. Second, the inherent instability of the price stabilization mechanism, which the company may be reluctant to acknowledge, would also disappear because the unstable mechanism would be 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 is trading well below $100. The company can try to finance coupon payments for as long as possible by issuing new shares or selling Bitcoin, even if Bitcoin prices are well below the average purchase price, or if the stock is trading at a deep discount to mNAV (per share net asset value). The trouble with this approach is that it is essentially buying time. The company claims it now has a large cash buffer, but once that money runs out, we will be back to where we were without a buffer. The problem is that for a $10.5 billion issuance, an 11.5% rate represents a huge cash drain relative to the current balance sheet size. The STRC product has an inherently unstable price stabilization mechanism and significant uncertainty regarding the direction of coupon policy. Resolving this uncertainty and fixing the issue as soon as possible might be the best choice for both the company and Bitcoin. However, taking the path of least resistance, refusing to admit being wrong, and letting the plan run longer as long as they can get away with it is tempting.

Before discussing how to fix the problem, perhaps there is 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 investments fall to around $55. This arrangement might be achieved through discussions between the company and STRC holders. However, without legal enforcement, this would leave potential uncertainty about the long-term coupon.

If the company does want to fully resolve the issue, in our view, there are actually two realistic options:

1. Start repurchasing STRC

2. Completely abandon the price stabilization mechanism and reduce the rate to SOFR

Over the long term, we believe the company will eventually go down one of these paths, either by repurchasing some and then, if unable to buy back all outstanding shares, finally reducing the coupon to the SOFR rate (Secured Overnight Financing Rate).

It might be challenging for the company to find a reasonable justification for repurchasing STRC now, as it was just issued, and a buyback would represent a policy reversal. Of course, a buyback could also raise legal questions. Since the bond price is significantly influenced by market perception of coupon policy and signals sent by the company—and the company can control this by merely sending signals without taking any action—one could argue that the company buying back at a discount might be somewhat unfair. However, whichever path the company chooses, it may face legal challenges; for example, that AI bikini girl ad (the image attached at the top of this article) left ammunition. Under these circumstances, a buyback might be the best way out, with a buyback price based on the company's ability to raise funds by selling Bitcoin or issuing stock, while also set at a level that compromises between mitigating legal risk and enhancing shareholder value.

Currently, speculation in the market about a possible buyback may be supporting the price, causing the instrument to trade 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: The Farside Equity Fund holds no positions in MSTR or STRC. The content of this article should not be used as a basis for investment decisions nor be construed as advice to enter into any investment transaction.