in Capital Markets , Investor Briefings

Wednesday 7 December 2016

Lucia Cebotaru

at Ishka

lucia@ishkaglobal.com

Investor’s guide to aviation debt structures

Ishka continues its educational series of Insights and provides an overview of the most common debt structures available in aviation finance.

This second installment of Ishka’s guide to investing in aviation finance offers an overview of the most commonly available opportunities, with a brief discussion of each of the structures and their suitability to a specific investor objective.  

Aviation finance offers a wide variety of opportunities choices of debt format. Ishka includes a selection of questions potential investors should ask themselves before selecting an appropriate investment vehicle.
 

Sources of funding

The following are the main sources of aircraft financing of new deliveries, mid-life and end-of-life assets:
 

Capital markets

The share of capital markets in the financing of new deliveries has been growing steadily as they continue to prove deep sources of efficient capital for both lessors and airlines. 

According to Boeing, capital markets are on track to provide up to 40% of the new delivery finance. This is because they are able to provide a mix of investment vehicles with a variety of risk-return and annuity profiles.

Tenors vary from short to long term and minimum subscription amounts are generally smaller than in syndicated lending. The secondary markets exist for investors with active trading strategies.

Investors can choose terms which offer different levels of trade-off between investor protection and pricing levels.  

Capital markets instruments may be suitable for fixed income institutional investors such as pension funds, insurance companies and investment funds, whether they are constrained by ratings requirements or not. Investors also have a choice between unsecured and structured debt transactions secured on pools or portfolios of specific aircraft. 

The following are some of the investment vehicles available through capital markets:

EETCs (US and non-US)
 

EETCs are a type of corporate debt issued by and dependent on the credit quality of an airline and secured by collateral (a pool of aircraft). Issuances can be in the public markets or through a private offering (by arrangement with the help from the structuring agent). 

 EETCs are structured with certain enhancements (such as overcollateralization, liquidity facilities) that allow them to be rated by ratings agencies at a level higher than the corporate senior secured debt. 

Traditionally offered in the US for US-based airlines with tenors anywhere from 3 to 20 years, EETCs are now used by non-U.S. airlines as a relatively cheap source of capital.  Recent transactions offered coupons between c. a3.5% and ca. 5% for (better quality and therefore less risky) tranche A.  Because of an attractive risk profile, EETCs have been heavily oversubscribed in recent past.

Bonds

Bonds in aircraft finance can take the form of corporate unsecured or secured issuance.  Unsecured corporate bonds expose the investor to insolvency risk and provide no security over the issuer’s assets, and their rating usually reflects the corporate rating. Secured corporate bonds are backed by a security package which includes aircraft mortgages and an assignment of rights under lease agreements. As such, they attract lower pricing levels to reflect greater creditor protection in case of issuer insolvency. 

Note that bond market carries its own risks, since it is sensitive to macro factors and fiscal policy, interest rate risk, inflation risk, underlying performance of the economy and strength of equity markets. 
 

Aircaft ABS transactions
 

Asset-backed securitisations (ABS) are similar to secured corporate bonds but, are structured to provide enhanced security to investors by ring-fencing the aircraft and related lease rights so that the investor is insulated from the risk of the underlying originator’s insolvency. A special purpose vehicle (SPV) normally owns the aircraft and then issues bonds to investors which are secured on cashflows generated by that aircraft equipment. The ABS structure, however, does not provide mitigation against difficulties or delays in recovering aircraft in a bankruptcy scenario.

ABS issued by operating lessors are typically enhanced through diversification across different aircraft types and airline credits, as well as the ability of the servicer to remarket the assets and through the use of liquidity facility. Typical liquidity facilities for most EETCs tend to be 18 months but the tenor can vary.

Recent market transactions saw coupons on higher tranches priced at between low 3% and high 4%, however, note must be made that the age and models of underlying aircraft varies from transaction to transaction).
 

Commercial bank debt
 

Commercial bank debt—may be unsecured or secured against assets and used to buy aircraft directly or indirectly.  Plain-vanilla loans funded by commercial banks (with or without export agencies’ support) were once a prevalent form of debt financing in aviation finance. These were for airlines with better credit profiles and lessors and, on the distribution side, made available to the underwriting bank and other financial investors through private placement. 

After a temporary retrenchment, following the financial crisis, commercial banks have renewed interest in aviation and are responsible for a 30% share in the funding mix and are expected to maintain that share in the medium term. Commercial bank debt is available through several different formats and is split between unsecured versus secured transactions, often utilizing a special purpose vehicle. Typical loan formats include revolving credit facilities and warehouse facilities among others.
 

Export credit agencies (ECAs)
 

Export credit agencies issue government-backed guarantees for commercial bank debt and bond transactions funded in capital markets, they also engage in direct lending if other sources of financing are unavailable to the borrower (these are usually lower credit quality).  ECAs stepped in to prevent funding disruptions in the years immediately following the financial crisis but have since seen their mandates revised and fees raised in the wake of regulatory changes and political pressure.  ECAs’ share in the financing mix for new aircraft deliveries has been declining (currently estimated at ca. 9%) and is expected to remain low in the near to medium term.

Lessors
 

Lessors deserve a special mention as they present an opportunity for equity or debt investments (lessors, for example, have been successful in accessing capital markets for capital-raising through bond issuances, ABS, portfolio selldowns, etc) and are in themselves providers of financing.  Investing in aircraft leasing platforms has been shown to deliver stable returns which outperform property, shipping or equities as a whole, and is less volatile than investing in airlines. 

Currently the predominant business model in the lessor sector is based on high leverage and as such critically hinges on availability of low cost financing; as such, lessors can be expected to continue to come to the market with issuances.  According to some observers, aircraft leasing platforms combined with active trading strategies may offer new investors healthy margins, lower volatility and returns on equity.  Particularly suitable for fixed income funds which seek low volatility of returns through the cycle.

Key questions for investors

Aviation finance offers a wide variety of opportunities, and a specific choice of format is only contingent on an investor's strategy.  Among other issues, an investor with an interest in aviation space may want to consider the following:

• Is my investment strategy active or passive?  Does the format of investment I am considering in aviation require active management and/or a technical skillset (as in, primary investment in an operating lease company)? 

• Is it a requirement under my strategy that any investment be highly liquid or publicly traded? 

• Does my strategy impose any constraints on my selection of investment opportunities with regard to investment rating? Geographic location or concentration? Credit quality of counterparties?

• Do I understand the drivers of change in the value of aircraft and their operators (airlines)? 

• Do I have a clear understanding of the production chain in aviation and the way macroeconomic and geopolitical factors influence it and, ultimately, aircraft values?

• Is my investment strategy compatible with exposure to US dollar?

• Am I comfortable with the fact that the principal drivers in the aviation industry—aircraft prices and fuel prices—are denominated in US dollars and/or would hedging arrangements be necessary—and to what extent—to mitigate currency risk? 

• Similarly, am I comfortable with the risk of exposure to US interest rates and would hedging be necessary to mitigate interest rate risk?

The Ishka View 

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: Eden, Janine and Jim