What it means
Traditional asset-backed securities pool familiar loans, such as car loans, and use the repayments to pay investors. Esoteric deals follow the same idea, but the assets are more specialised.
Examples include income from film rights, solar panel leases, cell towers, shipping containers, whole business revenue streams and even future legal settlement payments. The owner of the asset sells or pledges it to a special purpose vehicle (a separate legal entity created for the deal), which issues bonds to investors.
The cash flows from the assets pay interest and principal on the bonds. Because the assets sit in a separate entity, the investors look to them, and not the original owner, for repayment.
Investors are attracted by the higher yields that esoteric debt often offers compared with mainstream bonds. The extra return pays for extra risks, including less historical data, limited trading in the bonds and complexity in valuing the assets.
Careful analysis of the asset, the contracts and the legal structure is essential. Credit enhancement is often used to improve safety.
This might include extra assets over and above the amount of bonds issued, a reserve of cash or a ranking of bonds so that some absorb losses before others. Rating agencies examine the structure and assign ratings, although ratings on unusual assets may be harder to compare.
For the original owner, esoteric debt can be a cheaper source of funds than a bank loan or share sale, because the cost reflects the quality of the asset and not the whole business. The owner also keeps control of its operations.
The drawback is that the structures cost money to set up and require ongoing reporting. Risks include falling income from the assets, legal challenges, changes in technology or tastes, and the possibility that the market for the bonds dries up.
In a downturn, investors may find it hard to sell. Anyone buying these instruments should be comfortable holding them for the full term.
In practice
Real-world examples.
Example
A record label bundles the royalties from a catalogue of songs and issues bonds backed by the income. Investors receive payments from streaming and licensing revenue. The label uses the proceeds to buy more music rights.
Example
An airline lessor packages the lease payments on a group of aircraft into bonds. The lessees are several airlines, so the income is spread across customers. Investors receive interest from the lease payments over ten years.
Example
A company that owns mobile phone masts issues bonds backed by the rent from mobile operators. The long contracts give predictable income. The proceeds fund the construction of additional masts.
Formula
Calculation
Debt service coverage ratio = Cash flow available for debt service / Debt service
Worked example: A music royalty catalogue produces $5,000,000 of cash flow a year. The bonds issued against it require $4,000,000 a year in interest and principal.
Debt service coverage ratio = $5,000,000 / $4,000,000 = 1.25
A ratio of 1.25 means that the assets generate 25% more cash than is needed to pay the bonds, giving investors a modest cushion.Case study
Seen in the real world.
Harbourstone Studios is an illustrative, fictional film company that owned the rights to a library of older movies producing about $3,000,000 a year from broadcasting and streaming licences. Management wanted $20,000,000 to fund new productions but did not want to sell shares.
The company created a separate entity to hold the library rights and issued $20,000,000 of bonds backed by the licence income. Investors were offered a higher yield than on typical corporate bonds because the income depended on audience demand.
In this illustrative story, income fell short of forecasts in the third year as viewing habits changed, and the coverage ratio dropped close to 1.0. The reserve account covered the gap, and the bonds continued to pay. Management said they would be more cautious about the assumptions in any future deal.
Watch out
Common mistakes.
- Assuming a high yield means a good investment, when the extra yield compensates for greater risk and complexity.
- Skipping analysis of the legal structure, when the separation of the assets from the original owner is central to investor protection.
- Expecting to sell the bonds easily at any time, when trading in esoteric debt can be thin.
Questions
People also ask.
What counts as esoteric?
Any asset outside the mainstream categories of mortgages, auto loans, credit cards and student loans may be called esoteric, so the label is loose.
Who buys esoteric debt?
Institutional investors such as insurers, pension funds and specialist credit funds are the main buyers.
How is the risk managed?
Structures use extra assets, cash reserves, ranking of bonds and detailed reporting to protect investors.
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