What are convertible preferred bonds?
Convertible preferred bonds are a type of debt instrument (loan) that you (as an investor) can convert into common shares of the issuing company. But you might be wondering, what does 'preferred' mean here?
The term 'preferred' means that in the event of the company's bankruptcy, holders of these bonds will be prioritized for repayment over other creditors (such as holders of subordinated bonds or unsecured debt).
Here are some key terms related to convertible preferred bonds that you need to understand:
Principal amount: The initial amount that the company borrows.
Interest rate: The fixed or variable interest rate applied to the principal amount.
Maturity date: The date by which the company must repay the principal amount.
Conversion price: The predetermined stock price at which the bond can be converted into common shares.
Conversion ratio: The number of common shares that each bond can be converted into.
Why would a company issue convertible preferred bonds?
There are many reasons why the company chooses this type of financing, including:
Flexible financing: This type of instrument allows the company to raise capital, especially in the early stages or during periods of instability.
Avoid dilution of shares: Unlike traditional fundraising (selling shares), convertible bonds do not immediately reduce the ownership percentage of existing shareholders.
Tax benefits: In some cases, interest payments on convertible bonds may be tax-deductible for the company.
So, why do investors buy convertible preferred bonds?
Holders of convertible preferred bonds can participate in the company's growth through conversion into shares, making it more attractive than traditional debt. As this is a debt instrument with a fixed interest rate and a clear maturity date, investors are also protected against loss risks.
How convertible bonds work in Bitcoin investment
MicroStrategy is a prominent example of using convertible bonds to raise capital for Bitcoin purchases. Here is a simple explanation of how they work in this context:
The company issuing the bonds: A company involved in Bitcoin mining or related activities may issue convertible bonds to raise capital.
Investors buying the bonds: Investors who buy these bonds are essentially lending money to the company.
Interest rates and conversion rights: Bonds typically come with a fixed interest rate and a maturity date. Additionally, they provide investors with the right to convert the bonds into shares of the company at a predetermined conversion price.
Volatility linked to Bitcoin: If the company's business model is closely tied to Bitcoin, the company's stock value may fluctuate with Bitcoin's price.
Growth potential: If Bitcoin's price increases and the company performs well, the company's stock value can rise significantly, providing substantial returns for investors when they convert bonds into shares.
Risk protection: Convertible bonds are debt instruments that provide a certain level of protection. If the company fails, investors can still recover their initial investment (depending on the company's financial situation).
Source: Data Driven Investing How MicroStrategy Uses Convertible Preferred Bonds to Buy Bitcoin
Let's explore how MicroStrategy uses convertible preferred bonds to buy Bitcoin:
Issuing convertible bonds: The company has conducted several rounds of issuing convertible preferred bonds to raise capital. These bonds typically have a fixed maturity date and a 0% interest rate (zero-coupon), meaning no periodic interest payments are made. MicroStrategy began its Bitcoin strategy in 2020 with a cash purchase of $250 million. Since then, the company has raised over $3 billion through convertible bond offerings to continue purchasing more Bitcoin.
Use proceeds to buy Bitcoin: The funds raised from the bonds are primarily used to purchase Bitcoin, significantly increasing the amount of Bitcoin that MicroStrategy holds. As of December 3, 2024, the company owns approximately 402,100 BTC (equivalent to 1.915% of the total supply of 21 million BTC).
Leverage Bitcoin's potential: By heavily investing in Bitcoin, MicroStrategy aims to capitalize on the long-term price appreciation of this cryptocurrency. If Bitcoin's price rises, the value of the Bitcoin that the company holds also increases, potentially driving up the stock price of MicroStrategy (MSTR).
On November 20, 2024, MicroStrategy announced the issuance of $2.6 billion in convertible preferred bonds, maturing in 2029. Key points include:
0% interest rate (Zero-coupon): The bond does not pay periodic interest.
Conversion right: Bondholders can convert into common shares of MicroStrategy at a conversion price of $672.40 per share.
Maturity date: December 2029.
Call option: MicroStrategy has the right to repurchase the bonds starting in December 2026 if the company's stock price reaches 130% of the conversion price within a certain period. Upon repurchase, investors receive 100% of the face value plus accrued interest. Other factors may also affect the repurchase decision.
This strategy has yielded an annual profit of 80% for MicroStrategy from 2020 to 2024, surpassing even Bitcoin. Since mid-2020, MicroStrategy has outperformed all major stocks in the U.S., including Nvidia, thanks to its Bitcoin accumulation strategy.
The company's stock has increased by more than 2,500% since August 2020, while the price of Bitcoin has only risen by 660% during the same period. This performance highlights the significant impact of Bitcoin's price increase on MicroStrategy's success in the market.
However, investors need to be aware that the company's strategy carries high risks and significant volatility due to its heavy reliance on the long-term growth potential of Bitcoin.
Benefits of convertible preferred bonds
For companies like MicroStrategy, convertible preferred bonds provide the following benefits:
Reduce interest costs: The 0% interest rate (zero-coupon) structure allows the company to avoid periodic interest payments, thus lowering financial costs.
Lower issuance costs: Compared to traditional debt or issuing equity, convertible preferred bonds usually require lower initial costs. This is particularly evident when compared to issuing conventional debt or raising equity, which often requires a complex underwriting process (due diligence, pricing, and risk acceptance when issuing new securities) and higher fees.
Flexible capital raising: This instrument provides a way to raise funds flexibly without immediately diluting the ownership stakes of existing shareholders.
Attracting investors: Convertible bonds can be appealing to investors who want to access both the company's traditional business activities and its investment in Bitcoin.
Risks associated with convertible preferred bonds
Here are some potential risks to consider:
Bitcoin price volatility: The value of the Bitcoin that MicroStrategy holds may be significantly affected by price volatility, which can impact the company's financial performance.
Regulatory uncertainty: The regulatory environment for cryptocurrencies is constantly changing and may pose additional risks to the company.
Conversion risk: If MSTR's stock price falls below the conversion price, investors may be unwilling to convert the bonds into shares, which could lead to the dilution of existing shareholders' stakes.
Market timing and risk hedging risks: MicroStrategy is betting on the long-term price appreciation of Bitcoin — that is, assuming optimistic market prospects. If Bitcoin faces a prolonged bear market, this strategy could backfire, as the company would have to bear significant debt obligations and potentially see the value of its Bitcoin assets decrease.
Rising interest rates: Borrowing costs — especially in a rising interest rate environment — can add pressure on companies issuing hybrid financial instruments. Rising interest rates increase the cost of servicing debt, creating additional financial burdens for companies using this strategy.
Overall, the sustainability of MicroStrategy's bold strategy of using convertible preferred bonds to fund Bitcoin purchases depends on fundamental financial principles and the broader economic context.
The risks are particularly pronounced for investors who do not fully understand or agree with the rationale for holding a highly volatile asset like Bitcoin on the balance sheet. To ensure long-term sustainability, companies need to adopt a balanced approach that combines market analysis, risk management strategies, and flexible capital planning.
