Aircraft ABS -Value In A New Sector
July 26, 1999
By Thomas Zimmerman, senior vice president, Mortgage Strategy Group, PaineWebber, Inc.
During the past several years, two features have exemplified the asset-backed securities market - rapid growth and securitization of increasing numbers of new asset classes. Aircraft ABS is one of those new asset classes added to ABS. While not as large as home equities or cards, aircraft ABS do have the potential to become a significant category. And they currently trade at wider spreads than do larger, traditional, on-the-run ABS sectors.
For those investors willing to learn the details of a new category, the aircraft leasing sector offers some interesting opportunities. Since the sector's first leasing deal in 1992, six major aircraft leasing firms have used securitization to fund their activities. These include companies such as GPA, GE Capital Aviation Services (GECAS), International Lease Finance Company (ILFC), and Pegasus. With airline traffic growing rapidly, and the industry turning to non-traditional ways of funding aircraft, aircraft leasing is expected to grow rapidly over the next several years.
In this article we briefly review the evolution of structured aircraft financing, including both EETCs and aircraft ABS (since airlines may use either financing technique). We also spell out some basic issues an investor must deal with when considering an aircraft ABS deal.
Aircraft leasing deals require more investor home-work than do many other ABS collateral types. Financing, accounting and taxation are complicated, and often some collateral is domiciled in foreign countries. Also, aircraft leasing deals differ from typical ABS consumer finance deals. Instead of thousands of auto loans or hundreds of thousands of credit card accounts, a typical aircraft leasing deal may involve only 20 to 100 aircraft. Hence, the characteristics of every single aircraft and its specific financing become important, as do the attributes of each lessee.
Aircraft ABS do have several distinct advantages over other asset classes. Aircraft are quite (trans)portable, unlike CMBS. Aircraft designated for a particular region or overseas country can be shifted quickly to a different location if regional economics weaken in that territory. Also, aircraft do not face the same obsolescence risk that exists in high tech areas such as computers. Many safety and communication updates can easily be in-stalled into existing aircraft, which keeps "used" craft competitive with new models. Finally, the Federal Aviation Administration mandates maintenance schedules for all aircraft, making it highly unlikely that a lessee will abuse leased equipment.
Although economic upheavals in Asia and several other emerging areas slowed the growth in world airline passenger miles during the last two years, most observers view this as only a slight interruption in a long-term secular up-trend.
As integration of world economies continues and economic growth creates more affluent consumers - air traffic is expected to keep growing. Airbus Industries Global Market Forecast predicts that over the next twenty years, passenger traffic is expected to grow at 5%, with the highest regional growth in Asia (5.8%) and Europe (5.4%).
The passenger fleet is expected to double to approximately 19,000 in 2018, from around 10,000 jets today. Freighter growth rate is expected to be even greater, at 6.3% per year. The cargo fleet is expected to grow to 3,400 by 2018, from today's 1,450.
The Financing Gap
Traditionally, airlines used outside sources to fund their growth. Their internally generated funds typically fell far short of capital spending requirements, especially during recent years. This financing gap for 1991 to 1997 averaged around $19 billion/year. Passenger miles are also expected to expand rapidly over the next decade, fueling the growing need for financing.
In the past, airlines relied on banking coffers to satisfy their financial needs. Recently, a shift has occurred to new sources of funding, including several which utilize structured financing techniques.
Enhanced ETCs (EETCs)
The 1990-1993 industry downturn caused many airlines to lose their investment grade ratings. When ratings dropped below investment grade, the airlines lost a large number of investors who could not hold non-investment-grade securities. As airline traffic and new equipment needs started to recover in the mid-1990s, many airlines still had a below-investment-grade rating, which limited their access to funding. To meet their rising equipment needs, they turned to structured finance markets so as to create investment grade securities and broaden their investor base.
The result? Development of "Enhanced" ETCs (EETCs) and lease-backed ABS. An EETC is similar to an ETC (essentially an asset-based corporate bond) except that it is (a) structured with a series of credit tranches rather than a single class, and is (b) backed by a liquidity facility. That facility is available to pay interest for an eighteen month period. The rationale is that this is the time needed to remarket the aircraft lease in the event of airline bankruptcy.