This article is sponsored by Ostrum AM
In the aircraft industry there is a direct correlation between air traffic and the number of planes required. If we anticipate 4.7 percent growth per year over the next two decades – as outlined in Boeing Commercial Market Outlook 2018-2037 – that implies new needs for the sector and that old aircraft will have to be replaced. When we combine the two, we have 40,000 planes that will require financing.
Due to the amount of regulation affecting the banking sector, aircraft financing from capital markets and non-bank financial institutions has been growing. It is now an investment opportunity available in both public and private debt markets and is projected to nearly double from 2012 levels of $90 billion to $180 billion-plus by the end of 2022. Aircraft are used to service new routes, to increase traffic on a popular route or to replace retired ones. With demand for travel growing at a strong pace, operating lessors have been an important source of funding for airlines in a capital-intensive industry.
How aircraft lending works
Leasing companies and airlines use various types of financing to buy commercial aircraft from manufacturers such as Airbus, Boeing and Embraer. Deals are structured through investment vehicles – special purpose companies – that buy the plane and lease to an airline. What is key in aircraft debt structures is the mortgage on the asset that allows the lender to legally repossess it within a reasonable time. It is critical that the lender is then able to lease it or to sell it in the case of default.
Why it is one of the most secured debt markets
Aircraft are mobile and fungible assets. A plane operated by one airline can be operated by another anywhere around the world. An A320 belonging to Lufthansa’s fleet is still an A320 even if it is operated by LATAM in Brazil.
“When selecting assets, there is little publicly available information on aircraft secured debt and no secondary markets, so initial selection of assets is challenging and a key part of our job”
Aircraft debt is considered a secured investment, dependent on a stable asset, with low volatility. In addition, given that a plane’s economic life is around 25 years, the loan amortises faster than the financed aircraft value in standard structures. Both these features imply high recovery rates in the case of loan defaults.
A niche market characterised by several layers
Loans are not bought and sold on exchanges and there is only a very limited secondary market. Access is limited as making an investment requires full knowledge of the value chain, ranging from origination, structuration, analysis, selection, monitoring to understanding the legal documentation.
For example, sourcing opportunities requires having access to a network of banks, deal originators, airlines and private equity groups.
When selecting assets, there is little publicly available information on aircraft secured debt and no secondary markets, so initial selection of assets is challenging and a key part of our job. And each deal must be examined on several levels, including analysis of the corporate or counterparty, the asset itself and the structure of the deal.
“Loan and aircraft monitoring is also key in the process. If managed correctly, there are few, if any, unexpected losses when investing in aircraft debt”
In addition to illiquid trading markets, the asset itself can become illiquid. It is essential to know beforehand how easily the aircraft can be repossessed and sold to another airline.
In some countries, this process is easier than in others. Some, particularly the popular, narrow-body aircraft, are easier to trade than others.
ESG matters when selecting investment opportunities
Analysing an aircraft secured loan requires we calculate its probability of default and the loss given default, which derive respectively from the rating of the operator and from the comparison of outstanding debt and aircraft value throughout the lifecycle of the transaction. At Ostrum AM, we also integrate ESG considerations into the selection process. For example, lending to airlines with a poor record on social issues can create credit risk in the case of strikes, fines or loss of business.
Many features impact the potential loss given default, including loan to value, maturity, seniority, the local jurisdiction (which affects the time it takes to repossess), aircraft liquidity and value, or remarketing costs.
The return profile
Loan and aircraft monitoring are also key in the process. If managed correctly, there are few, if any, unexpected losses. Aircraft debt is one of the most secured debt markets, with an historical recovery rate of more than 98 percent (according a 2016 study by Aviation Working Group). This compares to a 77 percent recovery rate for senior infrastructure debt, according to Moody’s. The high recovery rates imply higher risk-adjusted returns compared to other fixed asset classes.
Yields start at 75 basis points above the interbank lending rate, which is a typical return for the financing of widely used narrow-bodied planes leased to a first-tier airline. Yields can also rise to 300bps above the interbank rate, and sometimes higher, for deals involving pools of old aircraft.
Margins have decreased slightly over the last 10 years since the financial crisis, but inefficiencies are an opportunity for experienced asset managers. These inefficiencies stem from the nature of the deals, which are transacted bilaterally or in small club deals. In aircraft debt, margins are not standardised as they are in large syndication deals. In fact, two transactions may have a similar risk profile yet very different pricing. This can happen, for example, if an airline has large financing needs due to lots of upcoming deliveries or if banks in a certain territory have higher funding costs, requiring higher margins. Both of these examples would imply increased returns for investors.
Ostrum AM has developed a front-office tool, allowing us to compare outstanding debt and aircraft value throughout the lifecycle of the asset. How quickly an aircraft can be repossessed is part of the value equation. The time for repossession can range from 60 days to a few years and depends on the jurisdiction where the asset is operated. Getting this equation right is critical when investing.
In addition to repossession analysis, Ostrum AM’s tool uses critical hypotheses such as loan to value, maturity of the debt, the age and expected values of the aircraft, and remarketing costs.
After investing, Ostrum AM differentiates with rigorous monitoring of loans and the aircraft. It is not enough to service the loan itself. The lender must also inspect the asset and be sure that the value of its collateral is still sufficient to cover the debt.
Aircraft debt has numerous attributes, including low correlation to other debt markets, regularity of capital and interest payments and low volatility. Although it is a niche market, it is not surprising that insurers have taken to the asset class. In 2019 and beyond, we believe the investor profile will widen further to include other types of investors, considering its attractive yield pickup and cashflow profile.
Loans to airlines and airline leasing companies – secured on aircraft – can provide long-term stable and predictable income and are also characterised by low volatility
The very high recovery rate on defaults is a positive attribute and contributes to attractive risk-adjusted returns versus comparable listed debt securities
Aircraft debt has been largely overlooked by investors. Diversification benefits are attracting institutions with long-term liabilities