20/12/2016

How will the US interest rate hike impact aviation?

How will the US interest rate hike impact aviation?

As widely expected the US Federal Reserve raised the federal funds rate by quarter of a percentage point to the 0.50%-0.75% range last week,  following months of mixed economic data in the US and market speculation. 

The hike is the first one since December 2015 and only the second one in the last eight years. Yet even more important than the actual increase is the Fed’s clear signal—and the markets’ apparent conviction—that this marks the start of an aggressive rate-hiking cycle, with as many as three 25bps increases envisaged for 2017. 

Whether the move will be followed by central banks in the UK and Eurozone at large remains to be seen as, despite regional variations, US monetary policy often sets the tone for policy changes elsewhere among western economies.

Upward movements in interest rates have deep implications for all economic agents—investors, businesses, and consumers—because the US prime rate is the primary determinant of financing costs in the US and an important driver of currency exchange rates.  Interest rate fluctuations are particularly meaningful for aviation, a capital-intensive industry which systemically relies on external capital (much of it US dollar-denominated) and whose primary inputs—fuel and aircraft—are transacted in US dollar-denominated markets.  

It is Ishka’s view that the low-interest-rate environment has been a significant contributor to the growth of operating lease companies worldwide and an important source of support for airline profitability. A series of rises in the relevant reference rates is, unsurprisingly, bound to have a dampening, if gradual, effect on the industry.  

 The interplay between various market forces following a change in the interest rate is highly complex but the most immediate impact will manifest itself in higher borrowing costs.  The exact scope of the effect will vary across geographies and industry segments. For lessors and airlines a prolonged cycle of interest rate hikes could potentially increase the cost of financing, curtail access to capital markets, and create a downward pressure on aircraft values. In addition there may be a possible drop-off in investment from non-traditional players. Larger established lessors and better-credit airlines with US dollar revenues are more likely to absorb, or otherwise be able to navigate this change.

 

Mechanism of interest rate changes: a quick primer
 


To recap, the federal funds rate is set by the Federal Reserve in the US and drives market interest rates both in the short term and, indirectly, long term.  It may take a change in the official rate up to 18 months to work its way through the economy. 

For short-term interest rates, a change in the official rate is immediately reflected in other short-term US dollar wholesale money-market rates, both in instruments of different maturity (such as mortgages and bank deposits) and in other short-term rates, such as interbank deposit rates. 

 The rates may not move in lockstep with the official rates, although commercial banks, for example, adjust their base lending rates by the exact amount of the policy change. This is turn influences other key financial market rates such as LIBOR, which is used to price  floating debt instruments in the aviation space.

For example, companies in the aviation space utilize various financial instruments that are subject to interest rate risk, which implies that a rise in the relevant rate will cause an increase in a company’s debt service obligations and will therefore have a direct negative impact on net income.

 Instruments widely used by firms in aviation may include short- and long-term investments, fixed-rate and floating rate debt obligations, and customer financing assets and liabilities. It is common for lessors, OEMs and some airlines to enter into hedging arrangements (such as interest rate swaps) to manage exposure to changes in relevant interest rates.   Sophisticated firms typically monitor unhedged exposure to minimize material gains or losses due to interest rate changes.

The changes in short-term rates, more generally, affect the spending and investment behaviour of firms and individuals in the economy, for example, discouraging capital expenditures by companies or encouraging individual saving.

 They also affect the market value of securities such as bonds and equities, and are often associated with increased market volatility in the immediate aftermath of policy changes.  The price of bonds, for example, is inversely related to the long-term rate, so a rise in long-term interest rates lowers bond prices.  Publicly listed airlines, OEMs and airlines will thus likely see moves in the prices of their equities, bonds and other traded securities.  Subinvestment-grade corporate bonds (most listed airlines belong to this category) will likely see a deeper impact on their yields.
 


The almighty dollar
 

All other things being equal, an increase in the base interest rate of a country will normally drive up the value of its currency against other currencies. For all intents and purposes, the functional currency of the global aviation industry is US dollars, and a sustained appreciation of the dollar will filter through the industry’s various sectors through a relative increase in the value of US denominated inflows (revenues) and outflows (e.g. fuel, some maintenance costs, lease rentals, some debt service).  For entities, such as the major lessors or US airlines, which receive substantially all of their revenue in US dollars and pay most of their expenses in that currency, foreign exchange risk is mitigated through a natural hedge (sophisticated players may also choose formally to hedge some of the currency mismatch between inflows and outflows).  Importantly, such entities may have an easier time maintaining access to the dollar capital markets.  
 


Lessors are the elephant in the room

 

Operating lease companies are now effectively responsible for financing 40% of new aircraft deliveries, and continue to trade heavily in the secondary market.  The potential effect of an interest rate hike on lessors’ capital needs and revenue streams has wide implications for the aviation industry at large. 

Such an effect may be particularly pronounced for those larger lessors that base their business strategy on a combination of asset risk and credit arbitrage, i.e. those lessors that act as capital providers in addition to managing “metal” and therefore taking on asset (residual value) risk.  Historically, lessors in this category actively used their borrowing capacity (perhaps through a parent company) for cheap unsecured debt to fund new deliveries.  In a cheap-funding environment, cost of financing thus becomes a source of competitive advantage; yet any adverse movements in the cost of funding may stress-test the financial robustness of a “capital provider”-type lessor.  RBS and AIG are some of the historic examples of lessors that came under pressure under such circumstances.

On the other hand, large modern-day leasing platforms generally engage in sophisticated multi-pronged liability management, specifically designed to safeguard their credit profile (and, for the publicly listed ones, investment grade) in the case of an overall downturn and/or adverse moves in one or more background market drivers (such as interest rates). 

It remains to be seen if the consistent efforts to optimise the diversification and credit profiles of lessee portfolio, to maintain moderate leverage and to mitigate interest rate and currency mismatch risks through match-funding are sufficient to secure lessors’ access to liquidity in the near term. 

 Clearly, any challenges in tapping traditional sources will have a knock-on effect on lessors’ ability to finance new deliveries and, by extension, on lease rates charged to lessees.

 

Mirror mirror on the wall, is aviation fairer than all?

 

As near-zero interest rates over the past seven years depressed yields for many asset classes, aviation benefitted from the influx of investment from non-traditional sources, which has been drawn to the industry’s relatively stable, higher risk-adjusted returns.  Competition over aviation over the past two years has bid up aircraft prices to the point where some of the traditional market participants have chosen not to deploy available liquidity for aircraft purchases.  Investor appetite has been strong for the young and mid-age, current-technology aircraft, and driven partly by availability of attractively priced financing. 

 

The changes in the interest rate environment will test the commitment of the newer entrants into aircraft finance.  Changes in financing terms, coupled with possible fluctuations in the credit quality of operators, may cause swift unravelling of recent transactions, laying bare mispricings, structural inadequacies of underlying transactions and the lack of technical expertise of some newer investors. 

Even in the absence of negative developments, newer investors with limited historic involvement in the aviation industry may reallocate capital away from aircraft finance on short notice as an increased interest rate causes the value and relative appeal of other, less technically demanding, asset classes to rise.
 


How will airlines be impacted?

 

A rise in interest rates may raise issues for non-US airlines, especially those with borderline credit profiles, which maintain significant US dollar-denominated liabilities in the face of weakening local currency.  A worsening in a credit profile typically means curtailed access to capital markets and/or bank loan pool and an increase in borrowing costs (to reflect higher risk and assessed in addition to the increase in the relevant base rate).  Airlines with a large proportion of leased fleet will be under pressure to preserve their credit quality even as they face the double whammy of increased cost of financing, both corporate and for any aircraft on lease, and a stronger US dollar. 

Airlines will be forced to reevaluate the relative cost-effectiveness of new aircraft versus used aircraft, as increased borrowing costs on the back of higher interest rates will be compared to operating expenses.
 

What of asset values?


An increase in the base interest rate will put downward pressure on aircraft prices, as the relative appeal of other asset classes drives away investor demand.  Importantly, lower asset prices have implications for financing terms: as the collateral value of aircraft diminishes, the pricing and terms of secured bank or capital market financing come under pressure.
 


The Ishka View
 


A sustained rise in interest rates is likely to increase the cost of borrowing for airlines and lessors.  It would also put pressure on the credit profile of non-US airlines, and aviation bond prices and is likely to diminish some investor appetite.

In the near to medium term, a rise in the US federal funds rate—even if it is followed by further hikes over the next 12 months—is unlikely to have an immediate negative effect on the cost of existing financing for larger, more sophisticated lessors.  The financial robustness of lessors will be stress-tested in the longer term, as future access to financing sources and the terms of such financing change in response to interest rate moves. Asset values are also likely to come under pressure and many new investors of aviation could be tested.

 As market forces come into interplay, it remains to be seen how airlines and smaller lessors will be able to manage an increase in the cost of debt. 
 

Please Note: The views expressed do not constitute investment advice. We accept no liability to recipients acting independently on its contents in respect of any losses, including, but not limited to profits, income, revenue or commercial opportunities.

Photo: shlomp-a-plompa

 

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