Hedge funds are making MicroStrategy the hottest deal on Wall Street

(Bloomberg) — To feed his billion-dollar appetite for Bitcoin, Michael Saylor tapped demand from retail investors captivated by MicroStrategy Inc.’s more than 500 percent rally this year. He has also benefited from hedge funds that don’t care much about where the stock trades.

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Eli Pars, co-chief investment officer of Calamos Advisors LLC, was among the buyers of more than $6 billion worth of convertible bonds that MicroStrategy sold this year to finance the purchase of its ever-growing cryptocurrency hoard. Like many other managers, Pars uses the notes to make market-neutral arbitrage bets that take advantage of rising volatility in the underlying asset.

“Convertible bonds are a way for issuers to monetize the volatility of their stocks, and MicroStrategy is an extreme example,” said Pars, whose company owns more than $130 million in MicroStrategy bonds in both long and arbitrage strategies .

Co-founder Saylor has accumulated more than $40 billion worth of Bitcoin over the past four years after deciding that the small business software maker needed to take a different path to survive. He accelerated the strategy shift in October by announcing plans to raise $42 billion over the next three years through an evenly split combination of stocks and fixed income. Since Oct. 31 alone, MicroStrategy has purchased about $13.5 billion worth of Bitcoin and issued $3 billion in interest-free convertible bonds, the company’s fifth bond offering this year.

Convertible arbitrage

These low-interest, long-term notes, with more than $7 billion outstanding, can be exchanged for shares if the stock price rises above a certain level. Hedge funds are buying them to deploy their own version of a convertible arbitrage tactic already used elsewhere by companies like AQR Capital Management and Man Group. It was one of the hottest strategies on Wall Street this year.

Although the tactics vary, convertible arbitrage traders generally use hedges to isolate the bonds’ conversion function and treat it as a stock option whose value is tied to the stock’s volatility. The more the stock fluctuates, the more profitable trading becomes – and MicroStrategy has been nothing short of turbulent. This year, MicroStrategy has seen an average daily move of 5.2% in either direction, compared to 0.6% for the S&P 500 Index.

Shares rose as much as 9.6% to $444.95 in New York on Thursday as Bitcoin broke $100,000 for the first time.

Saylor pointed to volatility as a selling point when he unveiled his capital-raising plan during an October earnings call with investors and analysts. He noted that the company’s stock is more volatile than that of any other member of the S&P 500. The momentum is driven in part by the sharp fluctuations in the price of Bitcoin, which has more than doubled this year. Additionally, MicroStrategy has been trading at a premium of more than 200% to the value of the Bitcoins it holds, a level that could also contribute to volatility.

Another appeal for Wall Street pros is the pricing of MicroStrategy’s convertible bonds, which is relatively cheap and would allow them to lock in potentially juicy arbitrage profits. MicroStrategy is the world’s largest issuer of convertible bonds this year.

“Trading is attractive because the implied volume of conversions is well below realized volume or implied options volume,” Pars said. Even in the convertible bond universe, MicroStrategy is a “very rare opportunity,” especially given the size and number of issues, he said.

In addition to Calamos Partners, the top holders of MicroStrategy’s bonds include Linden Advisors, Context Capital, Graham Capital and Millennium Management, according to Bloomberg.

“Musical Chairs”

The near-limitless demand from price-agnostic speculators is an important part of what some have jokingly called Saylor’s perpetual motion money machine. It allows MicroStrategy to repeatedly raise money to keep Bitcoin high by buying in droves, thereby increasing the value of its shares. The danger lies in the possibility of the cryptocurrency’s massive year-long rally reversing. In this case, increasing leverage on their value could have serious consequences for their owners.

“It could be a huge house of cards that will crush a lot of shareholders if it collapses,” said David Trainer, CEO of research firm New Constructs LLC. “There is no fundamental advantage here. It’s become a game of musical chairs, you play until the music stops and just hope you get out before the crash.”

MicroStrategy sells shares through an “at-the-market” offering program, which allows its investment banks to create shares and sell them at market prices, with the proceeds added to its balance sheet.

“Our job is to bridge the traditional capital markets that want bonds or fixed income or stocks or options, and we connect that with the crypto economy and use Bitcoin to do that,” Saylor said during an event in December. 3 interview on CNBC. MicroStrategy did not respond to a request for comment from Bloomberg.

While the convertible arbitrage community is relatively protected from wild price swings due to the hedging of their positions, the company’s credit profile poses a material risk to their trading, tied to one of the riskiest asset classes and Saylor’s unparalleled strategy.

“If Bitcoin corrects and the premium of MicroStrategy’s Bitcoin holdings over debt falls, this will impact the creditworthiness of converts,” said David Clott, portfolio manager at convertible bond specialist Wellesley Asset Management. “Trade now appears to be somewhat asymmetrical to the downside.”

However, as long as volatility remains high and Bitcoin trades within a reasonable price range, the arbitrage opportunity may prove too tempting to resist.

– With support from Dan Wilchins, David Marino and Subrat Patnaik.

(Updates MicroStrategy’s Bitcoin holdings value in fourth paragraph, stock movement in seventh paragraph.)

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Hedge funds are making MicroStrategy the hottest deal on Wall Street

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