The temptation and trap of 11.5%: Can STRC recover 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 has 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, then the company would need to increase the dividend rate, which could further worsen the company's credit profile, potentially leading to a downward "death spiral."

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

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

• Can MSTR afford the dividends?

• Should you invest in STRC?

• Will STRC return to par?

• What should Strategy do now?

Should you 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 an 11.5% coupon, 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, this is a bad deal. If someone offered us a perpetual loan at 11.5% per year to buy Bitcoin, we would refuse. This rate, 11.5%, is simply too high.

For example, Bitcoin might appreciate at an average of 10% per year. Long-term inflation might be 5%. Even so, Bitcoin could still be considered a massive success, perhaps even 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.

Furthermore, 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 could also be periods of decline. To pay interest, Bitcoin might need to be sold at low prices. This could also lead to net losses for the issuer, even if the debt never needs to be repaid.

We've 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 assuming dividend payments stay stable at 11.5%, this tool calculates a value of $144 for STRC, well above the $100 issue price.

Therefore, in our view, if we assume the coupon is stable at 11.5%, or assume 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 terrible deal.

So, should you borrow at 11.5% 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 decide at its own discretion to adjust the coupon rate. 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 around 3.6%). The company can do this without any penalty.

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 to buy Bitcoin under these terms is an excellent deal for the borrower and a terrible deal for the lender (investor).

Inherent Contradiction

STRC's issue price is neither $55 nor $144, but $100. Therefore, the price itself embodies a great deal of uncertainty around 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 its $100 target. The company has not responded by raising the coupon, likely due to fears 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, the instrument should not trade at $100 but well above it.

However, this does mean the price stabilization mechanism is largely defunct. It may not be 100% defunct because the company could argue that the mechanism has a ceiling. 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 that is indeed the case—that 11.5% is the top of the rate range—then it further highlights that issuing the product at this rate was too high. It's safe to say that if there is a rate cap, the company should only issue new STRC when there is a significant buffer (e.g., at least 2%) between the rate 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 bounce back to $100. With the price stabilization mechanism broken and no redemption mechanism, the $100 price really holds no special significance going forward. 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 it reaches 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 dividend payments would become quite affordable, and concerns about their cash flow issues should dissipate. Another problem—the inherent instability of the price stabilization mechanism, which the company may be reluctant to acknowledge—would also disappear, as this 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 trades well below $100. The company can try to fund the coupon payments for as long as possible by issuing new shares or selling Bitcoin, even if Bitcoin's price is far below the average purchase price, or if the stock sells at a steep discount to mNAV (net asset value per share). The trouble with this approach is that it's essentially buying time. The company claims to have a large cash buffer now, but once that money runs out, we're back to a state with no buffer. The problem is that for a $10.5 billion issuance, an 11.5% rate represents a massive cash drain relative to the current balance sheet size. The STRC product has an inherently unstable price stabilization mechanism and significant uncertainty about the direction of coupon policy. Resolving this uncertainty and fixing the problem as soon as possible might be the best option for both the company and Bitcoin. However, taking the path of least resistance—not admitting fault and letting the plan run longer while they can get away with it—is tempting.

Before discussing how to solve 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 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 the long-term coupon.

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

1. Start buying back STRC

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

Over the long term, we believe the company will eventually follow one of these paths, either buying back a portion first and eventually lowering the coupon to SOFR if unable to repurchase all outstanding shares.

It might be challenging for the company to find a reasonable justification for buying back STRC now, since it was just issued, and doing so would represent a policy reversal. Additionally, a buyback could also raise legal questions. Since the bond price is heavily influenced by market perceptions of coupon policy and signals from the company—and the company can exert control purely through signaling without taking any action—one could argue that the company buying back at a discount might be slightly unfair. However, whichever path the company chooses, it may face legal challenges, such as that AI bikini girl ad (the picture at the top of this article) leaves room for criticism. In this case, a buyback might be the best way out, with the buyback price based on the company's ability to raise funds by selling Bitcoin or issuing stock, while also set at a level that balances reducing legal risk and enhancing shareholder value.

Current market speculation about a possible buyback 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 finally succumbs to pressure and faces reality.

Disclosure: 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 should it be interpreted as advice to enter into any investment transaction.