The Allure and Pitfall of 11.5%: Can STRC Rebound to $100? What Should Strategy Do?

Source: Farside Investor; Compiled by: Claw from Jinse Finance

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

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, and then the company would need to raise the dividend rate, potentially worsening its credit condition and possibly 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. 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 needs a solution in the long term.

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% to buy Bitcoin?

Before considering STRC, it's worth looking at this transaction 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, it's a bad deal. If someone offered us a perpetual loan with 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 of 10% per year. Long-term inflation might be 5%. Even so, Bitcoin would be considered a huge success and maybe even heading toward "Bitcoinization," but it still wouldn't achieve an 11.5% annual growth rate. Therefore, issuing this perpetual instrument will negatively impact the issuer's balance sheet in the long run.

Moreover, Bitcoin's price does not 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, it might be necessary to sell Bitcoin when prices are low. This could also lead to 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, far above the $100 issue price.

Therefore, in our view, if we assume the coupon remains stable at 11.5%, or if we assume 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 good investment. In short, we believe that 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 far more complex than a perpetual bond with a fixed 11.5% coupon. It has a price stabilization mechanism, and MSTR can unilaterally decide to 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 about 3.6%). The company faces no penalty for doing so.

Using the Farside calculator again, when this factor is considered and the net present value of future cash flows is calculated, we estimate the tool's value at $55.

$55 is far below $100. Therefore, borrowing to buy Bitcoin under these terms 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 contains a great deal of 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, possibly because they fear a downward death spiral, or because they already consider 11.5% high enough. Indeed, assuming a reasonable discount rate and the company remains solvent, with a fixed 11.5% coupon, the instrument should not trade at $100 but well above $100.

However, this does mean the price stabilization mechanism has largely failed. It may not be 100% failed because the company could argue that the mechanism has a cap. That is, the company might raise the coupon to try to get back 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's the case—that 11.5% is the top of the rate range—then it further shows that issuing the product at this rate was too high in the first place. It is certain that if there is a cap on the rate, the company should only issue new STRC when there is a sufficient 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 price stabilization mechanism failing and no redemption mechanism, the $100 price indeed holds no special significance going forward. Those claiming the instrument will return to this price may be overly optimistic.

Another potential consequence of the failure of the 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 so, 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 issues should disappear. Another problem, the inherent instability of the price stabilization mechanism that 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 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 trades at a deep discount to mNAV (net asset value per share). The problem with this approach is that it is essentially buying time. The company claims it now has a large cash buffer, but once that money is used up, we will be back to a state without a buffer. The issue is that for a $10.5 billion issued product, an 11.5% rate is 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 now and fixing the problem as soon as possible is likely the best option for both the company and Bitcoin. However, taking the path of least resistance, not admitting being wrong, and letting the plan continue longer as long as it can get by, is very tempting.

Before discussing how to solve the problem, perhaps there is one more thing the company could try. The company could directly announce a coupon reduction 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 completely solve the problem, 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 follow one of these paths, or first repurchase a portion and then ultimately lower the coupon to the SOFR rate if unable to buy back all outstanding shares.

It might be challenging for the company to find a reasonable explanation for repurchasing STRC now, as it has just been issued, and a repurchase would represent a policy reversal. Of course, a repurchase 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 through signals alone without taking any action—one could argue that the company buying back at a discount might be slightly unfair. However, regardless of which path the company chooses, it may face legal challenges; for example, that AI bikini girl advertisement (the image at the top of this article) leaves a vulnerability. In this situation, a repurchase might be the best way out, with a repurchase price based on the company's ability to deploy capital from selling Bitcoin or issuing stock, and set at a level that compromises between mitigating legal risk and enhancing shareholder value.

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

Disclosure: The Farside equity fund holds no positions in MSTR or STRC. This content should not be used as a basis for investment decisions, nor should it be construed as advice to engage in any investment transaction.