Respondents were once again asked to rate their levels of optimism for the industry over the next 12 months in the various regions of the world. A score of 1 was the most pessimistic and 5 was the most optimistic.
Overall, the concerns were concentrated on certain pockets of the world – excessive growth in China and South East Asia, while positive, has also evoked concern over the ability to deliver the necessary supporting infrastructure and the ability of certain carriers to cope with building macroeconomic headwinds facing the sector over the next 12 months. India was the region where confidence was falling the most compared to last year in the wake of the continued troubles from their main carriers. The overwhelming majority of responses recognised that although India has the most potential for significant growth in air travel, it has failed to yet capitalise on this potential.
North America was viewed with the most optimism as all market players are confident that the major US carriers, in particular, are on a more secure financial footing than ever before and are well prepared for the coming downturn. There was also a sense that South American countries may be coming out of a prolonged slump, despite the significant political change in the region and signs of stress among some of the main carriers, Avianca Brazil being the most recent casualty.
Though still regarded as a strong market, Europe presented a very mixed picture for many. One respondent stated that his optimism level for Europe was both 5 and 1 – a facet of the muddy political climate with a lack of clarity on Brexit and other political issues. Fundamentally, respondents were in agreement that passenger growth would remain strong but given market stresses, further airline issues and consolidation were likely. The Middle East was also a concern, partly due to the geopolitical issues but mostly due to the big three Gulf carriers all vying for the same traffic and the fact that their business models are showing signs of stress. The African airline market has much, albeit still unrealised, potential with the ongoing challenges continuing to drive low levels of optimism.
Macroeconomic headwinds are impacting airlines around the world. Although those with strong cash management are coping with increased costs, signs of strain are showing in weaker carriers as airline profitability starts to be impacted by increased costs – specifically the oil price rises in the Autumn of 2018 –which is only now filtering through to the bottom line (although the retreat in price will give some reprieve).
Increasingly, as the market turns, there will be a division of the world’s airlines into two distinct groups: the first group that are financially strong and able to withstand a rising cost environment, and the second group that will show signs of weakness during the seasonal down period (which for most will be the winter period). Robert Martin, CEO of BOC Aviation, warns that this will be the most difficult winter period for airlines in the past five years: “While we believe the industry, as a whole, will be very profitable over the next year, there are going to be those airlines that are making a lot of profit – generally either in domestic US or with pricing power and international routes – and those that will suffer that generally sit in emerging markets with depreciating currencies against the US dollar and are particularly being hit by fuel costs.”
There are signs that some airlines are turning to leasing companies for assistance through the seasonal low period. “We have seen a number of customers – most pronounced in the past three months heading into winter in the Northern hemisphere – requesting maintenance reserve deferral to help cashflow through the winter,” says Mike Inglese, chief executive of Aircastle. “We are also seeing customers, in places where the strength of the dollar, the rise in oil prices and interest rates is a triplewhammy, starting to talk about deferring deliveries of newer aircraft as they look at their capital expenditure plans.”
Weaker airlines in Europe have found the operating environment far more difficult with six bankruptcies in 2018: Primera Air, VLM, Small Planet Airlines’ German and Polish units, Azur Airlines, SkyWork and Cobalt. UK regional carrier, Flybe has been put up for sale. Icelandair has broken covenants and failed in a bid to acquire troubled Wow Air, which may be acquired by Frontier parent, Indigo Partners. Norwegian too is continuing to struggle in the competitive marketplace. Further consolidation is expected in the European market as a result.
Airlines in North America are faring better; buoyed still by the efforts made in cost reduction and capacity management during the past few years. According to IATA, North American airlines are forecast to make net post-tax profits of $16.6bn in 2019, equal to $16.77 per passenger – the highest of any region. Moreover, despite economic recovery in larger South American markets such as Brazil, there are still signs of continued stress, with Avianca Brazil becoming the most recent airline casualty.
Geopolitical issues in the Middle East have been well documented with Qatar still experiencing some challenges with its neighbours. The real worry for banks and lessors, where this region is concerned, is airline overcapacity. “The Middle East market is worrying,” says Frank Wulf, global head of aircraft finance, Norddeutsche Landesbank (NordLB). “For years there has been overcapacity. Now with the dispute between the coalition and Qatar, you clearly see that this has an impact on economic development. Construction is falling, impacting both sides, not only Qatar. It is important to resolve this issue very quickly, but airlines are struggling because of the growing competition in this very narrow market. They all fly to the same destinations, they all run after the same passenger groups, so this is where I see quite a bit of tension that will kind of continue for the next one to two years.”
In Asia, despite traffic numbers remaining high, the major airlines have posted falls in profits for the latter half of 2018 after being hit by rising fuel costs, lower yields and intense competition.
The troubles faced by some Indian carriers are well known – Air India has been in financial difficulties for years and has failed to find a buyer, while Jet Airways is reported to be struggling to pay staff and seeking ways of raising funds as lessors begin to take back aircraft. Indian carriers face rising fuel costs in addition to rising state taxes. Even the healthier airlines have experienced difficulties caused mainly by the various technical problems with their new technology aircraft, and have either curtailed revenues or raised costs as they leased in additional capacity at short notice.
Airlines in Asia are particularly exposed to foreign exchange risk and are at the mercy of the fluctuations in the value of the US dollar. The fundamentals are positive for this region, particularly in China, with passenger demand continuing to rise alongside strong regional economic growth. However, this level of demand and market potential also gives rise to intense competition, which is putting pressure on yields on top of the rising operational costs. Most respondents from banks on this question point towards the stresses building in Asia as a cause for concern.
DVB’s Vincente Alava-Pons, managing director of aviation finance EMEA at DVB Bank, attributes the recent fall in airline fortunes in some regions to a lack of discipline.
“While the airline market has matured and overall airlines – specifically in the US – have become more disciplined, carriers in growth areas such as Asia are showing a lack of discipline,” says Alava- Pons. “Airlines that didn’t adjust their core structure in the good times will not be able to do so during the bad times.” Alava-Pons points to rising interest rates and rising fuel costs as signs of the cycle turning downwards, resulting in “bad times” for airlines that have lost the ability to pass on costs to the consumer – such as fare depression in very competitive markets.
“This is clearly happening in those markets and even some segments in Europe, carriers are unable to pass on costs,” he says.
Alok Wadhawan, head of aviation finance at Investec, agrees: “Fuel spiked at $80/bbl plus this year, if it returns to this level, it will place optimum pressure on airlines to raise their fares. [In areas in] Asia, that are far more price sensitive, as soon as fares rise, you will see a fall in travelling rate.”
He adds: “Asia is where the problems are in terms of emerging markets with oil prices and interest rates going up. A perfect storm could build up if this persists. In general, Asian airlines in quite a few countries are not as financially strong as their European and US counterparts because of competition, which is fast growing every year. The strength of the US dollar has put additional stress on emerging markets airlines – you see that in Turkey, South Africa, India and Indonesia, where the currencies have fallen by about 10-15%, plus oil has gone up by 10-15%. South America too is impacted by the same issues and signs of stress are building there too.”
Ruth Kelly, chief executive of Goshawk, states that airlines need to be assessed individually rather than regionally. She believes the most successful airlines – those able to ride out the current and approaching economic pressures – will be those carriers that are able to adapt to the changing conditions. “An airline’s ability to adapt in terms of its cost base, the flexibility of its cost base, its ability to downsize a little bit if it needs to, the flexibility and ability of the management team to foresee what’s coming, and plan and change in advance are all things that we would look for in terms of trying to pick the winning airlines,” she says.
AerCap’s chief executive officer, Aengus Kelly, is confident that airlines are insulated from the sharp shocks of the past that have previously brought down many large carriers, and although he agrees profits will fall, he does not foresee major airline bankruptcies: “We have been through a period of unprecedented airline profitability over the last several years and at the moment the industry is still profitable and can afford these increased costs,” he says. “It is no longer the case, where we were 10 or 15 years ago, where a surge in costs could quickly put quite a lot of significant airlines into bankruptcy. We don’t see that happening at the moment. We see reduced profit margins for sure but I don’t see the situation where major airlines will be falling over at the rate we saw historically.”
John Plueger, chief executive officer at Air Lease Corporation (ALC) is equally phlegmatic. “[The strong dollar] might dampen things in the short-term, but there have been many times in the last 10 years that we’ve had currency fluctuations and we’ve had a stronger rising dollar in the face of emerging markets. This is nothing unique. Airlines have shown an amazing adaptability to really deal and cope with this,” he says.
As passenger numbers continue to rise, airlines have demanded more lift from aircraft leasing companies, which have grown in scale and number.
In 2018, the leased aircraft portfolio increased by 629 aircraft to 8,109 aircraft, according to analysis from FlightAscend Consultancy, which has also identified that 100 new names have entered the commercial operating lease sector over the past decade.
“For me, the most interesting is the longer-term change, where 10 years after 2008 we have almost 100 new names in the commercial operating leasing space,” says Rob Morris, global head of consultancy at FlightAscend Consultancy. “Some of those are ownership changes (SMBC from RBS for example), but the vast majority are new entrants clearly attracted by the potential margins that operating leasing offers. Given recent margin compression driven by the increasingly competitive nature of the sector and also the propensity of new names in the lower echelons of today’s rankings, perhaps we are set for some wave of consolidation amongst the smaller players? And it certainly feels unlikely that in another ten years’ time we could have another 100 new entrants!”
There has been a much-discussed wall of liquidity that has entered the leasing space over the past few years, with Chinese banks famously entering the leasing sector in droves and a renewal of investment from private equity companies. This continued into 2018 with many more new leasing companies establishing – Zephyrus Aviation Capital (funded by Virgo Investment Group), Cerberus Aviation Capital, Sirius Aviation Capital, Skyworks/Elliott and Elevate, among others – with many more new sidecar and joint venture agreements also being established mostly by the more mature lessors to enlarge their ability to acquire aircraft off their balance sheets and to bring new investors into the sector.
Merger and acquisition (M&A) activity has also increased across the leasing spectrum. GIC, the Singapore sovereign investment fund, has invested in turboprop and regional aircraft specialist lessor, Nordic Aviation Capital (NAC), buying shares from both Martin Moller (NAC’s founder) and EQT VI (its partner since 2015). ORIX Aviation took a 30% stake in Avolon. The Carlyle Group bought Apollo Aviation Group, which operates more in the late midlife aircraft space. BBAM’s acquisition of Asia Aviation Capital’s fleet bumped its ranking back up to the top five leasing companies, while Goshawk’s acquisition of Sky Leasing Ireland boosted its fleet significantly.
Most market players agree that this M&A activity will continue. “People want scale,” says Stephen Hannahs, chief executive of Wings Capital. “Scale provides the ability to access different types of financing. Leasing is fundamentally a spread business at its core. You will see more acquisitions. There will be fewer players out there because more people are finding dance partners.”
“There’s huge demand in this space and any platform that has a decent fleet and a bit of scale would be a serious target,” agrees Fred Browne, chief executive officer of Aergo Capital, which is majority owned by private equity player, CarVal. “For the foreseeable future, the M&A trend is very real.”
Firoz Tarapore, chief executive of Dubai Aerospace Enterprise (DAE), which acquired AWAS, agrees that consolidation will continue but stresses that it has to be for the right reasons: “We have always maintained that if you are going to acquire a company, you have to do so because it further your strategic interests,” he says. “The two or three platforms that traded in 2018 were all strategic plays for the buyers. If there is a market event in 2019, this will cause many sellers – who are on the sidelines wringing their hands about how long they can continue to operate on a subscale basis – to accelerate their exit plans. For us, an acquisition has to be about more than just size.”
Over the past decade, there have been many new entrants into the leasing space. These entrants are bifurcated into those that are concentrated inside China and those outside, explains Khanh Tran, chief executive officer of Aviation Capital Group (ACG), which secured a minority equity investment from Tokyo Century Corporation in 2017. “For those outside China, there are a few names left that are looking for growth opportunities, but what is unclear is what will happen to the many smaller Chinese leasing companies – will they be acquisition targets for the larger Chinese lessors, or for those located outside of China?”
There are 60-plus leasing companies in China, a number widely considered to be unsustainable; most see the market within the country as ripe for largescale consolidation. “With the number of lessors that have entered the market over the past 24 months, there has to be more consolidation,” says Hani Kuzbari, managing director of Novus Aviation Capital. “Even within the established space, among the top 20 or 30 leasing companies, we will likely see a few come to market.”
This wall of liquidity and new entrants has created an ultra-competitive leasing environment as these companies strive to execute ambitious strategic growth plans. With the manufacturers’ delivery slots full until after 2020, lessors seeking to build new technology aircraft portfolios are forced into the already crowded sale-leaseback market.
Kieran Corr, global head of aviation finance at Standard Chartered, explains that as new entrants have come into the sale-leaseback market, the number of aircraft offered in the market has fallen: “There is a significant amount of liquidity chasing the same deals when you look at the number of players seeking to acquire new technology aircraft, and there is a smaller number of transactions,” he says, “which is depressing lease rates.”
Most lessors complain about the number of bidders on deals with airlines – especially in the sale-leaseback market – which is sometimes in excess of 30 bidders for one aircraft; this has served to drive down lease rate factors (LRFs) to sub-0.6 levels and in some cases sub- 0.5 levels. Airlines are seeking to take advantage of this market dynamic to demand that reduced or no covenants or other restrictions be placed on lessees, including reduced or no maintenance reserves and less stringent return conditions. This situation, however, is “People want scale. Scale provides the ability to access different types of financing. Leasing is fundamentally a spread business at its core. You will see more acquisitions. There will be fewer players out there because more people are finding dance partners.” Stephen Hannahs, Wings Capital viewed almost universally by lessors as unsustainable.
“We’re losing lots of transactions which we are hearing are being done at 0.5 levels,” says Goshawk’s Kelly. “We haven’t been able to be very active in the sale-leaseback market because we just haven’t been making that margin that we need to make at those kinds of lease rate factors. Some lessors must be doing transactions which have to be very marginal by our calculations.”
Peter Chang, CEO at CDB Aviation Lease Finance, described the current sale-leaseback margins as unsustainable because they contaminate the entire system. He blames airlines for over-ordering with the specific intent of flipping the aircraft to lessors. “The manufacturers make a sale to an airline, who order twice as many aircraft as they can use for their own airline operations, as a way to access working capital. The lessors are being asked upon to provide a service more than just intermediary in terms of the traditional sense of operating lease financing,” he says. Chang suggests that by placing bulk orders, airlines can order aircraft for significantly lower prices than leasing companies, and can then sell these aircraft onto the lessors in sale-leaseback transactions that value the aircraft at more than the capital cost, using the difference for working capital purposes.
“It’s a drug effect,” adds Chang, “and it’s not sustainable. The drug will wear off. Eventually, they have to go back to running the airline at a profit, and manage their fuel prices and group costs, etc. We’re allowing this cheap capital to seep into our business, and that causes a lot of unforeseen consequences. We will come to the point where many lessors are providing working capital to sustain an airline.”
Some market players comment that if the airline passes on its capital savings on an aircraft purchase to a lessor in a sale-leaseback transaction then, depending on the capital cost and over a 25 year period, a lease rate factor of 0.5 “may not be quite as bad as it seems”, but most still maintain that this business model is still unsustainable over the long term.
Brad Smith, chief executive of Kahala Aviation, says that the way lessors are incentivised now is pushing a shorter term goal of building market share and signing deals today, rather than focusing on longer-term returns.
“Incentives are much different today than they were a few years ago,” he says.
“Certain parts of the leasing sector has become more of an asset management industry and less of an investor driven industry. Ten years ago, people were still putting a lot of their own money into the deals and/ or they were getting paid mostly on a carried interest, so they were dependent on how successful the deals were and how much money the deals made.
Now, I think it’s become very much you’re going to get your salary and a bonus set on deal targets. I think people are perversely incentivised just to put on assets. The problem is you can buy an aircraft now and put it on a lease rate factor only marginally higher than the real depreciation rate and everyone high fives and has a nice closing dinner but the guy who is going to be taking those impairment charges might still be in high school because it’s going to be in 15 years before those deals start coming off lease.”
In such a fiercely competitive market, airlines are pushing lessors to provide pre-delivery payments (PDPs), to take multiple aircraft and reduce return conditions and maintenance reserves. “What I am pushing for more these days are shorter leases,” says an airline executive. “The good thing about long-term debt is that it is pre-payable, so if the situation changes, it can be refinanced or you sell the aircraft, but a long-term lease is locked in. Lessors are flexible, but leases are not.”
An emerging trend is for airlines to push for shorter leases on narrow-body aircraft from 12 to eight or even six years. This also has a positive impact on the airline’s balance sheet due to IFRS 16. “We have never bothered about the impact of leases on our balance sheet because analysts always calculated lease rental as eight times your adjusted debt. Now, they have to calculate that number accurately as a present value of your non-cancellable lease payments. If I have a 12- year lease, its double the balance sheet impact of a six-year lease, which is why I am pushing for shorter lease terms.”
Wings Capital’s Hannahs notes that more airlines are leasing aircraft for shorter periods. “Some customers have requested a six year lease for a brand new 777. When I asked why they want a short lease, their answer is because in this competitive environment they don’t know what their business model is going to look like after that period. They want a certain portion of their fleet to have flexibility to exit a type or exchange with a different aircraft,” he says. “Airlines look at leasing very differently today than in previous decades. It’s more of an active tool in the financial officer’s tool chest. Maybe in the 1980s it was more typical for airlines to lease to conserve capital or to efficiently utilise the tax attributes of the asset. It is only recently that airline profitability allowed them to effectively use the tax benefits associated with asset ownership.”
As well as a lower purchase price for aircraft, some lessors have very low cost of funds that can help lower LRFs to win deals. The place where many of these deals are being done, and with a profit, is in the JOL/JOLCO market, where the value of the tax depreciation available to Japanese aircraft owners is priced higher than for other owners which is driving a lower LRF.
Martin Bouzaima, chief executive office of FPG Amentum, which as the name suggests is majority owned by Tokyo-headquartered Financial Products Group (FPG), the largest JOLCO arranger in the Japanese market believes there are many drivers in play.
“The industry has this habit of looking at lease rate factors,” he says. “It is an easy metric, but is also distorted by a lot of factors. We have heard about LRFs in the low 0.5s, some SLBs even dipping just below 0.5. We tend to have lower LRFs for longer leases, obviously. Then there are some foreign currency deals, say in Yen or euros, or at least partially denominated in Yen or euros, which see lower US dollar-equivalent LRFs.
A further driver behind the low LRFs that have been observed recently is the residual value assumptions. The appraisers attribute a much lower longterm depreciation rate to NEO and MAX aircraft relative to CEO and NG aircraft. From what we see from a day-to-day trading aspect, the leasing industry overall seems to agree with this and that is probably the main driver behind the lower LRFs that we have been seeing.”
Aside from JOL market deals, AerCap’s Kelly suggests that LRFs as low as 0.5 remain uncommon and when LRF numbers are released to the market it is almost always by an airline. “What we do know about lease rate factors is a bit of an urban myth – the real numbers are very different,” says Kelly. “You might have a lease rate factor that’s quoted at 0.62 plus; 0.65 is probably where a lot of them are.
However, if it’s a 0.62, it’ll probably be in 2016 dollars, which then escalates or it’s subject to some form of adjustments on delivery. For someone to have a 0.7 lease rate factor, that’s 8.4% annualised yield; this does not cover costs. Those who have engaged in that market have generally taken a view that there’s a residual value upside and that they’re going to make a gain in those circumstances to get it through the approval process. That’s a very dubious thing to do but no doubt a small minority do. Look, if someone’s going to lose money, they won’t last a long time in the industry; the same as any business.”
Overall, the market does not see such low LRFs becoming commonplace but equally yields are unlikely to rise back over a 1% LRF since the market remains competitive and, for now at least, awash with liquidity. Additionally, given that the credit profile of airlines is so much stronger than it was 15-20 years ago, airlines are predicted to continue to push for a reduction or elimination of maintenance reserves to be replaced with letters of credit. Aengus Kelly doesn’t see this trend as negative or detrimental to the industry but he does warn lessors to be more wary. “If you are closing a sale-leaseback transaction with a very weak credit, a low lease rate factor and you don’t take maintenance reserves, then you’re going to get what you deserve sooner or later.”
The aviation bank market has been through a difficult decade following the global financial crisis. Many banks were hit hard by the fallout from the global financial crisis and the consequent downturn in the aviation cycle resulted in many banks exiting the aviation sector altogether. Some so-called “tourist” banks that had entered the sector before the crisis were very quick to disappear when times were hard but some more major banking players also exited the market. As the economy recovered, however, liquidity shifted back into the sector as investors searched for yield in more esoteric asset classes – which is how aviation assets were viewed – and banks sought to capture new sources of liquidity.
There was also a strong push to finance aircraft in the capital markets as bank debt dried up. That drip of aviation capital market deals has become a torrent, specifically for leasing companies issuing secured and unsecured bonds, and executing ABS deals. Airlines, too, issued more-competitively priced, enhanced equipment trust certificates (EETCs), some from non-US issuers, albeit at much lower levels. Only a few rated airlines are able to tap the capital markets, leaving many to tap the secured loan market.
Aided by new investors piling into the sector, aviation financing has become much more mainstream and therefore much more attractive. “Investors are much more comfortable with this asset class,” says Bertrand Dehouck, managing director and head of aviation finance EMEA, BNP Paribas. “It was viewed negatively for decades but post-2008, that thinking has gradually turned favourable as people witnessed the resilience and value of this sector. But investors also turned to this sector due to the lack of other opportunities, which is where the contraction will come, we believe, with the rise in interest rates when many investors may redirect their money away from aviation.”
New and old banks returned to the aviation banking sector tempted by margin and fee income from bank debt as well as capital market products. The return of the bank market, particularly over the past two to three years, has been impressive, but it has also resulted in far more competition.
“It is a changing market,” adds Dehouck. “There is a lot of liquidity and therefore a lot of competition. We have to know how to resist and adapt to the competition… We are a long-term player and have been in this market for 30-plus years so the modus operandi for us is to continue to run our platform across a wide variety of solutions for our clients.” More Chinese banks have also entered the sector on the banking side and other Asian banks are also very active, albeit less so in the capital markets, which tends to be dominated by US and European banks.
“Mainland Chinese banks are very active, although they are primarily focusing on their domestic market, plus maybe a handful of selected international carriers and lessors,” observes Frank Wulf, NordLB. “Asian banks outside of China are also fairly active, especially the Japanese, who are also being very aggressive in terms of pricing in order to secure new business. So, there’s substantial competition on the lending side for us as well as from the very active capital market, primarily in the US.”
Those investors that were courted by the banks following the crisis have become much more prolific investors in the sector lending cheaply directly to lessors, helping boost the leasing market specifically to the extent that many airlines would opt for sale-leaseback deals – which carry very low lease rate factors – as opposed to bank debt to fund their deliveries.
Much like in the leasing market, where increased competition has led to a lack of conditions such as maintenance reserves, banks are also reporting a loosening in security and covenants in the race to secure mandates.
“I see a definite increase in risk on the banking side,” says NordLB’s Wulf. “The standards of documentation, security documents in particular, have gone down. You would accept certain features in the documentation for, let’s say, smaller, less-experienced lessors that previously you would only accept for top notch lessors. So there’s a constant downward spiral and this reminds me very much of things prior to the last crisis. A lot of industry players, financiers, left the market and are quite oddly coming back now, so I’m a bit concerned that this is a recurring theme.”
Winston Yin of The Korean Development Bank (KDB), says that covenants are also becoming much less restrictive in such a competitive marketplace. “Many deals have almost no covenants and this is likely to continue unless there is a major correction,” he says. “On the secured debt side, requests for pricing to be as low as possible, with looser covenants and sizeable balloons are common. This is not a reflection of KDB as a conservative lender, but more a reflection of the markets and where deals are getting done, and where structures are being pushed aggressively. Banks have to be disciplined in this market but each to their own.
Some banks will have to go down the credit curve drastically in order to win some transactions, and others will have to adjust expectations. We’ve seen pricing tighten immensely over the past 12, 18 months, even within the last six months, so I think banks are taking the view that they would rather adjust their return expectations to win the deal than hold tight and end up with nothing.”
Bénédicte Bedaine-Renault, head of aviation finance EMEA at French bank Natixis, also sees these pressures on the banking market. “Covenants have lightened for the past few months, and we see that liquidity is driving obligors towards more flexible terms. Unsecured debt is increasing, notably for lessors which are already or aiming at being investment grade within the next few months. Duration and amortisation is not changing much, probably because the economic life of aircraft is not changing, although we could question that when checking the size of the open balloons contracted by banks in the market.”
Olivier Trauchessec, managing director – head of transportation Americas, MUFG Bank, views the current banking market as more measured: “I find that the bank market has been very disciplined for the past three to five years,” he says. “Banks can be very squeezed in terms of pricing, there’s no question. We see margins being quite low, and it can be difficult really to make money in the banking sector, especially in North America and in Europe. But, in terms of structure when you look at advanced rates, balloons, governance and increment, I don’t think that they’re too crazy. There has been a situation where we’ve seen some players who were very keen to position themselves for capital markets transactions that have provided favourable terms for a warehouse facility, but overall it’s been a fairly reasonable market, I find it to be optimistic that it is.”
Jennifer Villa Tennity, president of aviation lending at CIT Bank, agrees that maintaining discipline is paramount. “We have remained very disciplined even through the massive influx of capital into the lending space over the past few years. In our view, there are still well-structured transactions to be done with satisfactory loan-to-value ratios for both borrower and lender, realistic margins and good collateral. That said, if some of this capital does exit, we would expect more demand to flow to secured financings, less aggressiveness in terms of advance and margin, and less relaxation on covenants and the like in order to win transactions.”
While the low interest rate environment has helped airlines and lessors raise competitively priced funds, it has also impacted banking margins, with pricing remaining at very low levels. Most bankers therefore welcome the upward trend in interest rates, which – as Dehouck hopes – may eventually lead to a contraction in the level of market competition.
Banks are currently preparing for the impact of more restrictive regulations that could lead to a reduced balance sheet. Basel IV could require banks to hold more capital reserves against certain loans they issue. This would likely be the case for unsecured loans but secured loans might qualify as specialised finance which could allow them to continue to be assessed under existing Foundation and Advanced Internal Ratings based approaches, i.e no change. Where Basel IV requires more capital allocation, it should cause banks to increase pricing; however, the competitive marketplace makes it very difficult for them to execute such a strategy.
One banker agreed that a bank’s ability to offer long-term secured financing could be reduced, if impacted, and there will be a shift – more so than there was after the financial crisis – towards banks distributing their loans more widely and to new channels such as insurance companies, pensions funds, asset managers and others. “More structures will also likely be developed,” he says, “more structured and secured private placements.”
European banks would likely be more impacted by Basel IV (if more capital needs to be allocated against aviation debt) and are making plans to restructure their product offerings to remain competitive.
Non Basel banks, however, are preparing to capitalise on the restrictions that Basel IV could impose on their competitors by using their balance sheet to offer long-term financing that will not be curtailed under the new capital environment.
This new environment may also force a return of support from the Export Credit Agencies (ECAs) and the US Export Import Bank (Eximbank) if bank debt becomes prohibitively expensive. Likewise, demand for insurance-backed products from AFIC and Balthazar will rise, along with demand for capital markets products.
Over the past year, the aviation economic cycle has continued to be rather benign with no sharp falls. However, market participants broadly agree that the cycle has peaked but rather than suffering a steep decline, the market is undergoing a slow correction, with one respondent describing the past few years as a “mini cycle”.
“I do see a correction in progress,” says one airline executive, “Over the past few years, many airlines were profitable, which led them to add capacity and launch more routes but, as oil costs rose and competition put pressure on fares, yields began to fall and most airlines in Asia have now posted two quarters of falls. Although airlines in North America and Europe are still posting profits, they are making less with even the larger carriers issuing profit warnings. There is always this delay or lag because airlines can’t react quickly enough to spikes such as oil price rises. I don’t think there is going to be a plummet to the bottom of the cycle; this is just a correction or a mini-cycle, and we are just now reaching the bottom. Hopefully now, the cycle will turn and slowly rise, rather than rocket back up.”
Many support the notion that the market will continue to experience, a gradual correction as opposed to a sharp fall, with growth likely to have peaked. The building headwinds are expected to worsen, however, and most banks consider the current macroeconomic environment to be the sign that the cycle has turned.
“The macroeconomic environment is not particularly supporting of further strong medium-term growth,” says Arnaud Fiscel, head of transportation, corporate banking department, Bank of China (UK). “In light of higher costs and demand – at best – at par, it is legitimate to expect shrinking profits for airlines, with gradually weakening cash positions and potentially further bankruptcies or consolidation of weakest players. From that perspective, recent price softening on commodities markets is welcome; since the tail end of 2018 we have indeed observed that most astute players have been benefiting from the significantly improving market conditions to fill in their fuel hedging books.”
Wadhawan, too, agrees that the airline market is in decline, as demonstrated by the fact that many carriers are reporting falling operating margins. Vinodh Srinivasan, managing director and cohead of the structured credit group at Mizhuo Securities views the current aviation cycle as being in the process of normalising rather than contracting.
Some of the legacy carriers, the more mature leasing companies and the aviation banks are welcoming a turn in the market, and viewing it as an opportunity rather than a threat to their business because it will reduce the competitive landscape.
AerCap’s Kelly, however, does not predict a largescale reduction in competition in a downturn scenario. “I don’t think we’re going to see a mass exodus from the industry because the industry’s a very investible sector,” he says. “At the right returns, it’s a growth industry, it’s a global business, it’s got hard assets, dollar assets – these are very attractive aspects for investors. A lot of capital that has come into the industry will stay but I think we’ll see a good chunk leave when the going gets tough.”
The increase in debt providers should mean less asset volatility than what was witnessed 20 years ago, says Kelly. “Twenty years ago you might have had a good asset like a 737 or an A320 but that didn’t matter because the absence of debt capital meant that the volatility of the asset was very high. Twenty years ago there was a handful of banks in the world who could take and hold $100million in a syndicated facility, but that’s nothing today. We have over 20 lenders in Taiwan alone. This is a huge change in the industry.
There is now a lot more understanding of the industry by the debt providers and the management teams are far more professional. When the going gets tough, I think you’ll still find significant pools of dedicated capital for good assets. Now if you have a bad asset you’re going to struggle, that’s for sure.”
The impression for many bankers is that those aviation banks that remained in the sector through the difficult postcrisis period and for those that came back are now more prepared for a stressed situation.
“Banks are better prepared, they are also willing to probably invest a bit more into areas like asset management, more detailed research into aircraft, more detailed appraisals, looking for instance, for things like the maintenance condition of the aircraft, which is very important in a problem situation,” says DVB’s Alava-Pons. “Banks probably would be more prepared to actually stick it out and stay in the business. Overall, the bank market is better prepared. This doesn’t apply for everybody, of course. We have already seen one or two banks, which were probably testing the aviation market, also stopping again but it’s not really representative.”
For the largest lessors, the rating agencies are bullish on their continued success and ability to ride out choppier economic waters. “The larger lessors we rate have experienced management teams who have gone through these downturns before, who have good airline relationships and good credit departments, so they’re on top of this situation,” says S&P’s Snyder.
Rises in interest rates do not impact leasing companies in the same way as airlines, and in fact some leasing respondents have actually welcomed the rising interest rate environment, since it pushes up inflation that assists companies that own depreciating assets, as well as allowing them to increase lease rates that are currently at very low levels for new aircraft types, specifically.
“Rising interest rates should bring up lease rates in the long-term,” says Fred Browne, CEO of Aergo Capital. “But in the short-term there is an oversupply of aircraft that is keeping rates low.”
AerCap’s Kelly agrees that rate rises can be good but only when they are accompanied by an improving economy: “That is generally when you have your most profitable periods because you do see inflation and asset prices increase.” But, he warns, this depends on the velocity of the rate rise. A sudden spike makes it harder for lessors to pass on costs to lessees, which is what happened during the financial crisis.
Wings Capital’s Hannahs adds that this transition from a low interest rate environment to higher rates will be difficult since although the correlation between interest rates and lease rates is high, there is a delay between rates rising and higher lease rates. “Stable interest rates are better; once you get to a higher rate environment, lease rates will eventually adjust,” he says.
Further concerns were aired by respondents that rising interest rates could be detrimental for some leasing companies, particularly those that may have mismatched liabilities and revenue. “A lessor who is rolling in commercial paper and has a lot of fixed rate leases is going to be hit quite hard,” warns Robert Korn, president and co-founder of Carlyle Aviation Group (previously Apollo Aviation Group), which is a prolific issuer of ABS paper that allows the company to lock in fixed rate, longterm funding. “I don’t see interest rates being beneficial in a rising market for any lessor, other than serving to kick competitors out of the way,” he adds.
Some leasing companies have been fixing lease rates for lessees in a bid to win deals; however, in a rising interest rate environment, lessors that are not term matched may not be able to recover these extra costs when they rollover debt or refinance bonds.
Korn adds that rising interest rates will create “unplanned financing costs for some lessors that will create distressed sale opportunities which could be advantageous for us”.
S&P’s Snyder sees such a scenario as a serious issue for the broader market. “What does concern me is the amount of liquidity chasing these assets,” says Snyder. “There are some new investors in this space, and some new startup lessors, and I’m concerned about how they’ll respond if airlines come under pressure because they don’t have the remarketing expertise. They may be more inclined to lease and/or sell their aircraft at any rate.”
Stronger leasing companies are expected to be better able to manage the fallout from the rise in interest rates than some competitors. That fallout could potentially involve repossessing and replacing aircraft. Airlines would suffer from rises in interest rates, particularly the knock on effects on foreign currencies against the US dollar. On the flip side, there is an inflection point in the interest rate cycle where leasing aircraft becomes more attractive than ownership, but that is also dependent on the availability of capital and the depth of the money available for individual airlines.
Many lessors are seeking an investment grade rating because the leasing business is so capital intensive. ORIX Aviation’s Meyler describes an investment grade rating as “fundamental” and it becomes even more important in a downturn and rising interest rate environment.
“It’s all about the liability side of the balance sheet in terms of how you can compete, especially when you’re competing with companies that have a very strong investment grade rating, such as ALC or SMBC, or that have a parent company with a very high credit rating like ORIX,” he says. “The availability of those companies to access debt at significantly cheaper cost than you; if you don’t, you’re not on a level playing field… There’s no question that to be - at least in the newer aircraft space, you either have to be investment grade or you have to be owned by someone who’s investment grade to be able to compete in this market in the future.”
Aircastle achieved an investment grade rating in 2018, which was the endgame in a specific strategy for the leasing company to reduce its secured debt funding. “This business is about funding, and if you look at the income statement, the two biggest expenses are interest and depreciation,” says Inglese. “I can’t really control depreciation, but I can try to control funding cost, which is a function of my credit rating and my leverage.”
Aircastle began its unsecured debt transformation over eight years ago. In the period before the financial crisis, the company had 100% secured debt, borrowed from traditional aviation banks and financed in the ABS market. Post-crisis however, the vast majority of those funding sources evaporated that led Aircastle, along with many other companies, to revitalise their funding strategies and work to attract new sources of capital.
“In late 2009, early 2010, we were seeing investment opportunities that would yield double-digit unlevered returns, but there was no bank that would lend money to buy a 10-year-old airplane, and there was no ABS market,” Inglese recalls. “In order to seize those investment opportunities, we had to find a new source of debt capital. Having achieved investment grade recently, and having just completed our inaugural capital raise with the BBB- ratings, is an important part of maintaining our place in the mid-age marketplace as a disciplined investor who will find opportunities regardless of market conditions. The investment grade market is much deeper and much broader than the high yield market, and we think that having that access and maintaining that rating will be an important differentiator going forward.”
Many in the industry believe that the financial crisis put existing companies on a more secure footing after they broadened their sources of funding. However, there are an equal amount of people in the industry who believe that those lessons have been forgotten during the elongated upcycle and amid the flood of liquidity – and new competition – into the sector.
Barrett remains confident of the future for the business in a downturn environment and sees more competition as an opportunity. “It is a more challenging market,” he says. “There is still a lot of capital in the industry and there are many new entrants and that can be a challenge. But we are very well positioned – we are well capitalised with a high quality fleet; we have a strong experienced platform with many customers located around the world. More competition is also an opportunity since many new lessors want to buy assets and we are happy to sell to them.”