Over the past couple of years, an unprecedented amount of institutional investor capital has poured into the acquisition of music royalty assets. From private equity firms to pension funds and even public market mutual funds, this appetite is growing in lockstep with the overall rise of interest in alternative and uncorrelated asset classes (we’ve written about this more broadly here). More specifically, the cash-paying nature of royalties has created a narrative around music catalogs becoming an alternative to traditional high-yield fixed income assets, such as corporate bonds.
We completely agree that the underlying cash flows derived from music royalties are, in fact, uncorrelated to the macroeconomic forces that drive traditional fixed income instruments. However, we’d argue that at the current point in the cycle, the value of royalty assets is much more closely linked to macro forces — and, specifically, interest rates — than investors are giving credit.
Let’s understand why the prevailing narrative exists, what investors are actually buying, and ultimately why there’s more correlation than meets the eye.
The typical rationale for allocators and investors to acquire music royalties is to supplement the portion of their portfolios that pays a predictable income stream with something that isn’t tied to economic cycles. If this uncorrelated piece of the pie can potentially generate a higher rate of return vis-à-vis owning corporate or municipal debt by virtue of illiquidity, even better.
As recently as 2014–2015, this narrative seemed to make sense. Investors could buy a high-yield corporate bond of, say, Sprint, which was paying investors 7.3%, or 5.4% above the risk-free rate as measured by the 10-year US Treasury. Meanwhile, royalties of high-quality music catalogs were changing hands at prices that implied 10–12% annual distributions to investors. These catalogs certainly wouldn’t be as easy to sell as a corporate bond of Sprint Corp, but the incremental 3–5% of return seemed adequate compensation for the illiquidity.
Around the same time, the music industry started growing, and the fundraising machine kicked into full effect while general investor risk appetite grew. Fast forward a few years, and a similar Sprint bond now yields ~6.4% (~4.3% above risk-free) while sellers of high-quality music royalty assets are demanding 15x cash flow (implying a ~6.7% yield to the buyer or ~4.6% above risk-free).
Okay, but isn’t an uncorrelated 6.7% still an attractive diversifier to a corporate bond that yields 6.4% and is definitely tied to the macroeconomic cycle? The reality is more nuanced.
First, we must remind ourselves of a fundamental difference in these two asset classes:
- Traditional fixed income — i.e. debt — implies an obligation of a borrower to repay the principal advanced by an investor. Absent a fundamentally negative hit to the borrower’s financial wherewithal, the investor is not ‘on the hook’ to figure out how to get its money back: it’s spelled out in a contract — Sprint owes that money back to its lenders on a specific date.
- Owning royalty-generating copyrights is fundamentally owning equity of an asset that the investor controls. There’s no borrower on the other side of the transaction to pay back the invested capital. Thus, crystallizing value in the future fully depends on the ability to sell the asset to a willing buyer at some undefined point in the future.
Next, let’s simulate what happens when one of the most prevalent macroeconomic factors — interest rates — change. Let’s assume interest rates go up by 1%, with the 10-year Treasury (our risk-free proxy) following to 3.1% by 2026, the maturity of the Sprint bond chosen in our prior example. Let’s also conservatively assume that in 2026 investors require the same excess return (additional yield) above what they can get risk-free for risky assets such as bonds or royalties. Lastly, let’s assume the underlying cash flows of the royalty assets stayed flat and Sprint’s business has not deteriorated meaningfully.
The investor who bought $100 of Sprint bonds in 2019 does not worry about principal loss, to the extent the underlying business has retained its value — the repayment obligations at maturity are still intact regardless of the prevailing market rates.
The investor who purchased $100 of music royalties, however, faces a different proposition. After clipping a 6.7% distribution for 7 years, nobody is there to contractually write a check. To preserve its original capital, the investor must sell the asset by finding a new buyer who is willing to pay the same price from 2019. However, the price implying 6.7% yield is now less interesting to the marginal buyer, since the marginal buyer should now want to make at least 7.7% (4.6% over the new risk-free rate). To pour salt on the wound, Sprint’s next bond issuance at 7.4% now looks more attractive to the yield-seeking investor, especially considering an investor can buy and sell the bond with no friction. An alternative to traditional fixed income is no longer as critical.
Thus this new buyer may simply walk away unless the owner of the royalty asset is willing to lower the price until the effective yield is at least 7.7%. That implies at least a 13% loss of principal.
In simpler terms: that uncorrelated fixed income alternative investment is uncorrelated only until you want your money back!
While the math of this exercise hasn’t changed between 2014 and 2019, the margin of safety in 2014 was significantly higher, as evidenced by the 12% yield on music royalties. In effect, the increasing use of royalty assets as a fixed income replacement has killed any buffer and has made the asset class highly dependent on macroeconomic factors such as interest rates.
Today, we fear investors who have found comfort in a predictable income stream that feels worlds away from Wall Street are, in fact, making an implicit bet that macroeconomic forces such as interest rates don’t change…a prediction that even the most seasoned Wall Street pros usually get wrong!
Notes and caveats:
- We’re ignoring impacts of inflation for simplicity
- We’re assuming a wide-sweeping “ceteris paribus” regarding other things that may drive investor interest or fear of a particular asset class
- We chose Sprint as it’s a large, familiar household name. Sprint has had a lot going on that has impacted its capital structure, we recognize. An analysis of other corporate bonds of similar credit quality would make the point just as well