Convertible Bond

Convertible bonds are hybrid financial products that incorporate features of both debt and equity. Issuers raise capital through bond sales, offering periodic interest payments and a fixed maturity date. Investors, in turn, have the option to convert the bonds into equity shares at a predetermined conversion rate.

The convertible market has experienced significant growth recently. This year's convertible debt issuance is expected to reach $70-$80 billion—40% higher than in 2023. Crypto deals have emerged as a major driver of convertible activity in 2024. While Boeing Co.'s $5.75 billion mandatory convertible preferred stock offering—part of a larger effort to shore up its balance sheet—was the year's largest single equity-linked transaction, MicroStrategy Corp. has raised $6.2 billion through convertible bonds, inspiring others to follow its Bitcoin-buying strategy.

Crypto-space issuers have offered particularly attractive terms, with some bonds carrying zero coupons. According to Citi's Duffield, these favorable terms stem from increased equity market volatility and benchmark indices trading at or near record highs.

Crypto-Backed Convertible Bond

Crypto-backed convertible bonds are increasingly favored by public companies looking to raise capital while leveraging the growing potential of digital assets. By blending debt with the option for equity conversion, crypto-backed convertible bonds appeal to both issuers and investors seeking a balanced risk-return profile. Unlike traditional convertible bonds, these instruments extend their utility by directing proceeds toward cryptocurrency-focused activities such as acquiring digital assets, scaling mining operations, and advancing blockchain-based services.

Crypto-backed convertible bonds provide multiple incentives for investors. As debt instruments, they offer downside protection through regular interest payments, reducing exposure to cryptocurrency’s inherent volatility. At the same time, the equity conversion option allows investors to benefit from potential stock price appreciation driven by the issuer’s successful crypto strategy. This dual nature makes them an attractive option for investors seeking both income and growth opportunities.

The adoption of crypto-backed convertible bonds has grown significantly, with several leading companies raising substantial funds. For example, MARA Holdings has issued $2.2 billion in zero-coupon bonds, using the proceeds for Bitcoin purchases and mining expansion. From 2020 to 2024, the total proceeds raised through these bonds exceeded $15 billion globally. The average coupon rates for these bonds range from 0.5% to 3%, significantly lower than traditional corporate debt, reflecting the added value of the equity conversion option.

Despite their advantages, crypto-backed convertible bonds carry inherent risks. The volatility of cryptocurrency markets can significantly impact the value of acquired assets and issuer stock performance. For example, MicroStrategy experienced a 40% drop in its stock price during the 2022 bear market due to Bitcoin’s decline. Regulatory uncertainty also poses challenges, particularly for mining-focused companies that face scrutiny over energy consumption and environmental impacts. Additionally, the success of these bonds depends heavily on the issuer’s ability to execute its crypto strategy effectively. Poor management or operational inefficiencies could erode investor confidence and returns. Finally, bond-to-equity conversion can dilute existing shareholders, potentially leading to stock price depreciation.

Current Landscape

MicroStrategy remains the largest issuer of convertible bonds, raising over $6 billion to fund its Bitcoin acquisition strategy.

Under the leadership of Michael Saylor, MicroStrategy has positioned itself as a pioneer, utilizing convertible debt to acquire Bitcoin as a treasury reserve asset. By offering low-interest debt, MicroStrategy capitalized on robust institutional and retail demand, deploying the proceeds into Bitcoin purchases. As of late 2024, the company holds 423,650 BTC, valued at over $41.5 billion, representing approximately 2% of the total Bitcoin supply. This aggressive strategy has not only fortified MicroStrategy’s financial profile but also inspired a wave of imitators, establishing a precedent for corporate capital allocation in the cryptocurrency space.

Coinbase and Block Inc. follow closely with proceeds exceeding $2 billion each, focusing on operational growth and Bitcoin ecosystem integration, respectively.

Block Inc. (formerly Square Inc.), a financial services company, has issued three convertible bonds totaling $3.65 billion to support its Bitcoin-focused initiatives and blockchain integration. These include a 0.125% Convertible Senior Note due 2025, a 0.25% Convertible Senior Note due 2026, and a 0.50% Convertible Senior Note due 2027, with proceeds allocated to scaling its Bitcoin ecosystem through the Cash App, merchant solutions, and Bitcoin custody services. Block also holds approximately 8,000 BTC, reflecting its commitment to Bitcoin adoption as a corporate strategy. Additionally, the company invests in open-source blockchain projects, such as decentralized Bitcoin mining, to advance its mission of making Bitcoin more accessible. Despite its innovative approach, Block faces challenges from cryptocurrency market volatility and regulatory pressures.

Mining-focused companies like MARA Holdings, Riot Platforms, and Terawulf use convertible bonds to scale operations and acquire Bitcoin, leveraging mining profitability.

MARA Holdings Inc., a leading cryptocurrency mining firm, has raised $2.2 billion through convertible bond sales, positioning itself as a significant player in the market. The company has strategically used the proceeds to expand its mining operations, acquire additional Bitcoin, and manage debt obligations. With approximately 12,000 BTC in holdings, MARA demonstrates its commitment to leveraging Bitcoin as a treasury asset. However, the company faces challenges stemming from its dependence on Bitcoin price fluctuations and regulatory scrutiny, which could affect its profitability and operational stability.

Riot Platforms Inc., a leading Bitcoin mining company, has issued a $500 million convertible bond, with an option for an additional $75 million, to finance its operations and Bitcoin acquisition strategy. The proceeds from this issuance are allocated to purchasing mining hardware, expanding infrastructure, and acquiring Bitcoin to strengthen its balance sheet. Riot holds approximately 11,425 BTC as of late 2024, underscoring its commitment to growing its mining capacity and leveraging Bitcoin as a strategic reserve asset. By focusing on scaling operations, Riot seeks to enhance profitability and competitiveness in the crypto-mining sector. However, its success heavily depends on Bitcoin price stability, energy costs, and regulatory frameworks impacting mining operations.

Terawulf Inc. distinguishes itself in the market by aligning cryptocurrency mining with sustainable practices. The company raised $500 million in convertible debt, deploying the funds to integrate renewable energy sources into its mining operations. This approach not only addresses growing environmental concerns but also appeals to investors seeking eco-conscious investment opportunities. Terawulf’s strategy positions it as a leader in sustainable mining, providing a competitive edge in a market often criticized for its environmental impact.

WisdomTree and Strive Asset Management demonstrate the growing interest in crypto-related financial products, emphasizing ETFs and tokenized investments.

WisdomTree Inc., a prominent asset management firm, has utilized convertible bonds to advance its footprint in the cryptocurrency and blockchain sector. The company has issued two key bonds: a 3.25% Convertible Senior Note due 2023, raising $150 million, and a 5.75% Convertible Senior Note due 2028, raising another $150 million. These bonds have funded WisdomTree’s efforts to innovate in cryptocurrency-focused exchange-traded funds (ETFs) and blockchain-based investment products, providing traditional investors with regulated exposure to digital assets. By integrating blockchain technology, WisdomTree has aimed to tokenize traditional assets and enhance efficiency, positioning itself as a leader in crypto-financial products. However, its success depends on navigating regulatory challenges and market volatility, which remain key risks in its strategic expansion.

Strive Asset Management has proposed an innovative strategy to introduce a Bitcoin-backed ETF utilizing convertible bonds issued by companies like MicroStrategy. This ETF aims to provide institutional and retail investors with indirect exposure to Bitcoin through regulated financial products, avoiding the complexities of directly holding cryptocurrencies. Strive’s approach highlights the growing demand for crypto-related investment vehicles that bridge traditional and digital finance. By investing in convertible bonds tied to Bitcoin purchases, the ETF offers a diversified risk-return profile appealing to cautious investors. However, Strive’s success depends on obtaining regulatory approvals, ensuring transparency, and maintaining robust risk management practices in a rapidly evolving cryptocurrency market.

Strategies of Issuers

Companies across various industries have adopted diverse strategies to leverage these bonds, maximizing value, mitigating risks, and aligning with their specific goals.

1. Bitcoin Accumulation as a Treasury Asset

One of the most prominent strategies involves using proceeds from convertible bonds to accumulate Bitcoin as a treasury reserve. Pioneered by MicroStrategy, this approach transforms Bitcoin into a core balance sheet asset. Companies raise funds through low-interest convertible bonds and allocate them to purchasing Bitcoin, particularly during favorable market conditions or price dips. This strategy capitalizes on Bitcoin’s potential as "digital gold," offering a hedge against inflation and a store of long-term value. However, this approach is not without risks, as companies remain exposed to Bitcoin’s price volatility and potential balance sheet vulnerabilities during bear markets.

2. Scaling Cryptocurrency Mining Operations

Another widely adopted strategy is scaling cryptocurrency mining operations. Companies like MARA Holdings, Riot Platforms, and Core Scientific use proceeds from convertible bonds to expand their mining infrastructure, purchase cutting-edge hardware, and enhance energy capabilities. Bitcoin mined during operations becomes a key revenue source, providing operational leverage as Bitcoin prices rise. However, this strategy comes with significant risks, including high energy costs, regulatory scrutiny, and profitability challenges during prolonged bear markets.

A noteworthy strategy that combines environmental sustainability with cryptocurrency is integrating renewable energy into mining operations. Terawulf has pioneered this approach, using convertible bond proceeds to develop mining infrastructure powered by renewable energy sources. This strategy addresses growing environmental concerns surrounding Bitcoin mining while appealing to eco-conscious investors. By reducing carbon footprints and improving efficiency, companies like Terawulf position themselves as leaders in sustainable mining. However, the high upfront capital expenditures and reliance on consistent renewable energy availability present challenges.

3. Diversifying Revenue Streams

Some companies have diversified their revenue streams by investing proceeds into broader cryptocurrency services. Firms like Galaxy Digital and Coinbase allocate funds to trading, asset management, staking, and lending services. By offering a wide range of crypto-related financial products, these companies position themselves as comprehensive players in the digital asset ecosystem. This approach reduces dependency on Bitcoin prices and attracts institutional clients. However, managing diverse services requires substantial expertise and resources and comes with the added challenge of navigating regulatory uncertainty in areas like staking and lending.

4. Hedging Against Market Volatility

Issuing crypto-backed convertible bonds also serves as a hedge against market volatility, offering a hybrid financial product appealing to equity and debt investors. These bonds allow investors to gain indirect exposure to cryptocurrency while reducing the risks of direct holdings. Investors benefit from downside protection through regular interest payments while retaining the option to convert bonds into equity at favorable rates. This strategy provides issuers with a low-cost method to raise funds and investors with a balanced risk-return profile. However, during periods of high market volatility, conversion terms may become less favorable, and stock prices may not align with the company’s crypto strategy.

5. Bitcoin-Backed ETFs

Lastly, the introduction of Bitcoin-backed ETFs represents an innovative use of convertible bonds. Strive Asset Management has proposed an ETF that invests in bonds issued by companies like MicroStrategy, which use the proceeds to acquire Bitcoin. This approach allows institutional investors to access the cryptocurrency market indirectly through regulated financial products. While this strategy diversifies exposure to Bitcoin-backed corporate strategies, it also depends heavily on the performance of the underlying bonds and faces regulatory challenges.

Returns and Tax Implications for Investors

Highlights

1. Deferral of Taxes: Convertible bonds provide a key tax advantage by deferring taxes until the bond is sold or converted.

2. Capital Gains vs. Ordinary Income: Conversion itself is not a taxable event, but subsequent sales are subject to capital gains tax. Interest income is taxed as ordinary income.

3. Special Cases (OID/Dividends): OID and dividends have distinct tax treatments, with OID taxed as ordinary income and dividends potentially qualifying for lower rates.

4. Cryptocurrency Exposure: Crypto-backed convertible bonds offer the same tax deferral advantages as traditional convertible bonds, with added protection against volatility.

Crypto-backed convertible bonds present unique tax advantages compared to direct cryptocurrency holdings, making them an appealing choice for both investors and issuers. These financial instruments allow investors to defer taxable events and strategically plan their tax obligations while providing issuers with access to capital at potentially lower costs.

Convertible bonds are treated as debt instruments under U.S. tax laws, and investors are required to report interest income on their annual tax returns. For example, a holder of MicroStrategy’s Convertible Senior Notes due 2027 would not report interest income due to the bond’s zero-coupon nature but would need to account for capital gains or losses upon selling or converting the bond. Conversion of the bonds into equity is typically a non-taxable event, enabling investors to defer taxes until the converted equity is sold. The tax basis of the acquired equity equals the original cost of the bond, and the holding period of the bond contributes to achieving long-term capital gains treatment, which is taxed at a lower rate than ordinary income.

In contrast, cryptocurrency transactions, such as selling or exchanging Bitcoin, trigger immediate capital gains or losses based on the difference between the asset's fair market value at disposition and the acquisition cost. For example, if an individual purchased Bitcoin at $30,000 and sold it at $60,000, the $30,000 gain would be taxed at either short-term or long-term rates, depending on how long the Bitcoin was held. Additionally, income generated through staking or mining cryptocurrencies is taxed as ordinary income at the time of receipt, with the recipient establishing a new cost basis for future transactions.

Deferral of Taxes

The ability to defer taxable events is one of the most significant advantages of crypto-backed convertible bonds. Unlike direct cryptocurrency holdings, which require taxpayers to report gains and losses for each transaction, bondholders are only taxed on interest income until the bond is sold or converted. For instance, if Coinbase’s 0.50% Convertible Senior Notes due 2026 appreciate due to the company's growth or rising cryptocurrency valuations, the bondholder can defer realizing taxable gains until they choose to convert or sell the bond, even if the bond’s underlying value increases tenfold.

Cryptocurrency Exposure

Moreover, crypto-backed convertible bonds offer protection against cryptocurrency market volatility. With bonds, investors benefit from fixed-income components and only face taxable events when interest is paid or the bond is liquidated. For example, Riot Platforms’ $500 million convertible bonds allow investors to earn interest and defer tax liabilities on potential gains tied to the company’s growing Bitcoin holdings, which stood at 11,425 BTC as of late 2024.

From a compliance perspective, the IRS requires all interest income from convertible bonds to be reported, typically via Form 1099-INT and Schedule B. Capital gains or losses upon sale or conversion are reported on Schedule D and Form 8949. In comparison, cryptocurrency transactions are subject to stricter scrutiny, with every sale, exchange, or transfer requiring detailed reporting on Form 8949. Failure to report cryptocurrency transactions accurately has resulted in penalties, with the IRS increasingly targeting crypto investors for audits.

Growing Popularity

In real-world terms, the tax deferral advantage of convertible bonds can be seen in their growing popularity among investors looking to minimize taxable events while benefiting from exposure to the cryptocurrency market. For instance, MicroStrategy’s $6.16 billion in convertible bond issuances allows investors to avoid immediate capital gains taxes that would otherwise apply if they directly held Bitcoin. Similarly, Coinbase’s convertible bonds provide investors with exposure to the company’s performance and the broader cryptocurrency market without the immediate tax burden associated with direct digital asset transactions.

In conclusion, crypto-backed convertible bonds are a compelling option for investors seeking to optimize tax strategies while gaining exposure to digital assets. By deferring taxable events and offering strategic conversion opportunities, these instruments provide an effective way to balance risk and reward in the evolving cryptocurrency market. However, investors must remain vigilant about compliance requirements and consult tax professionals to navigate the complexities of these instruments.

Special thanks to all the people in the arena for the thoughtful conversations & feedback that all went into putting this piece together.

Disclaimer: This post is for general informational purposes only and does not constitute investment advice, recommendations, or a solicitation to buy or sell any securities. It should not be used as the basis for making any investment decision and should not be relied upon for accounting, legal, tax advice, or investment recommendations. You are encouraged to consult your own advisers regarding legal, business, tax, or other related matters concerning any investment decisions. Certain information included here may have been obtained from third-party sources, including portfolio companies of funds managed by Aquarius. The opinions expressed in this post are those of the authors and do not necessarily reflect the views of Aquarius or its affiliates. These opinions are subject to change without notice and may not be updated.