We live in a world of scarce resources, especially our finances and risk capital. Because alternative investments such as royalty assets should only account for a fraction of a diversified portfolio, we must make rational and thoughtful choices about choosing the best assets and paying the right price. Investment is a process of thinking. You can't invest in anything at any price and expect to outperform long-term.
When it comes to music royalties, the entry price is important because music royalties are income streams. As with bonds and dividend-paying stocks, the higher the price, the lower the effective yield and vice-versa. Just as one evaluates a stock's valuation relative to the P/E of the overall market, a royalty asset's initial yield can be compared to other fixed-income investments.
As discussed previously, an asset's initial yield can be determined by dividing income by the price. For example, Dave Gibson music royalties recently sold on Royalty Exchange, Inc. for $12,800. Based on the previous 3-years' average royalties of $2,874, the expected initial yield is [($2,874/3) / $12,800] or 22.45%.
This figure can and will change based on future use of the song. But the initial yield provides an indication of the asset's starting valuation relative to other opportunities.
Tara Kemp (Will Hammond) music royalty auction
Source: Royalty Exchange, Inc.
For example, the Will Hammond music royalty recently at auction (auction close 10/29/2014) on Royalty Exchange, Inc. has produced an average of $1,294/year over the past three years. Based on a $9,500 current price (and including the exchange closing fee), the initial yield would be approximately 12.84%.
Whether that yield is attractive depends on the overall interest rate environment. Earning 12% on an investment is appealing given the 10-year-government bond's current yield of 2.27%. The same 12% yield during the inflationary early 1980s when interest rates on US government bonds exceeded 10% would not have been considered attractive.
10-year Treasury Yield (25 = 2.5%)
The difference between an investment's yield and that of US Treasuries is known as the spread. Because US government bonds are devoid of credit risk, investments are compared relative to their spread against Treasuries as well as other comparable options. The bigger the spread, the higher the income, but also the higher the risk.
With the US 10-year yield at 2.27%, the Will Hammond royalty auction's spread is 10.57% above Treasuries. You're getting paid 10% more to hold the music royalty than to hold risk-free intermediate term bonds.
That's consistent with the current spot market for music royalties as evidenced by recent prices on Royalty Exchange, Inc., where music royalties have sold at initial yields between 11%-17%, or spreads between 9%-15% over Treasuries.
Just as we should know the stock market's valuation by means such as the P/E ratio before buying a stock, so should we be aware of the interest-rate environment before buying a royalty trust. If interest rates rise dramatically, you should expect the sale yield on music royalty auctions to rise as well.
Yields on Master-Limited-Partnerships (AMZ) compared to other income alternatives
Source: William Blair and Co.
While there is no index of music royalty investments (yet), we can look at an index of energy-related Master-Limited-Partnerships as a comparator.
This index shows current trading around a 3.25% spread to the 10-year Treasury bond according to data from William Blair and Company.
The spread is obviously higher for music royalties, but the spread narrows (and risk goes up) the more one initially pays. For this reason, basic comparative yield analysis is an ideal starting point when considering adding an income-stream such as music royalties to a diversified portfolio.
For more information on royalty investing check out these other Royalty Review articles by guest columnist and investment analyst, Jonathan Hoenig: