Airlines and aircraft lessors are increasingly looking to the debt capital markets as a source of funding. During the past 12 months or so, near-record levels of financings were completed in the primary securities markets accessed by airlines and aircraft lessors as compared to prior periods. Market commentators have reported that approximately $17 billion of aviation-related debt securities were sold in the U.S. capital markets in 2015, which represented a more than 20% increase over 2014. In 2016 to date, aviation-related debt securities issuance in these markets is already nearing $3 billion. A number of these offerings also achieved record pricing. Airlines have been issuing enhanced equipment trust certificates (EETCs) and unsecured bonds, while lessors have been issuing unsecured bonds and sponsoring aircraft and engine asset-backed securitizations (ABS). The proceeds from these debt securities are most often used to purchase aircraft, to refinance owned aircraft, to refinance other existing debt or for other general corporate purposes. Various forecasts predict strong levels of activity for the remainder of 2016 and in the following years.
Key Trends: Air Travel Demand, Fleet Growth and Regulatory Changes
What has been driving the aviation sector's increased use of debt capital markets financing? In addition to the current low-interest-rate environment, several key trends continue to be the principal drivers: air travel demand, fleet growth/renewal and regulatory changes.
First, passenger air travel demand continues to grow steadily. IATA recently announced passenger traffic results showing that demand (measured by revenue passenger kilometers (RPKs)) increased 6.5% in 2015 compared to 2014 and reported that the ten-year average annual growth rate in RPKs has been 5.5%.
Second, airlines have been meeting this demand growth by increasing their fleets or re-fleeting, using their owned aircraft and leased aircraft. Boeing reported delivering 762 aircraft to customers in 2015 with 5,795 aircraft still in backlog, and Airbus reported delivering 635 aircraft to customers in 2015 with 6,787 still in backlog. Combining these numbers, deliveries were being made by the two major manufacturers in 2015 at a rate of nearly four aircraft per day every day of the year. Bombardier, Embraer and other leading manufacturers are also steadily rolling new aircraft off their assembly lines. Market analysts predict that more than 36,000 commercial jets and turboprops will be delivered over the next 20 years, with a list price value of more than $2.5 trillion. Many of these aircraft purchases will be financed. Debt capital markets, particularly in the United States, are a natural leading source for that financing, given the markets’ depth, flexibility and familiarity with the aviation sector.
Third, regulatory changes are shifting debt financing markets and supporting increased demand for the debt capital markets instead of bank balance sheets. The reform measures of the Basel Committee on Banking Supervision, commonly known as Basel III, seek to strengthen the regulation, supervision and risk management of the banking sector. Increased capital adequacy requirements and other changes, such as the net stable funding ratio, are being phased in through 2019 and are expected to have significant effects on the loan market.
Another regulatory change has affected the market for credit backed by export-credit agencies (ECAs) which airlines and lessors use to finance their purchase of new aircraft. The revised minimum premium rates under the OECD's 2011 Aircraft Sector Understanding have increased the cost of ECA-supported financing and led airlines and lessors to look to other sources.
The depth of the U.S. capital markets for corporate debt issuance may be appreciated by looking at recent dollar volume. According to SIFMA, $1.5 trillion of new debt securities were issued by corporates in 2015, of which $1.23 trillion was investment grade and $260 billion was high yield. These markets had similar dollar volume issuance in the previous three years as well. Investors and money managers continue to search for yield, and certain aviation debt investments are providing them with opportunities to achieve attractive risk-adjusted returns.
Aviation DCM Activity in the U.S. Capital Markets: 2015 and 2016
So what have we seen in the U.S. capital markets since the beginning of 2015? Let's review the principal markets in order of U.S. dollar volume issuance during the period.
Given the trends discussed above, it will be no surprise that aircraft-backed secured debt securities have been issued in increasingly large volume. In the EETC market, 2015 dollar issuance volume was more than double that of 2014. By year-end, more than $7 billion of EETCs had been issued by eight airlines, financing 123 aircraft. First-time offerings by Turkish Airlines, LATAM Airlines Group, Spirit Airlines and Mesa Airlines came to market as well as repeat offerings by American, Air Canada, Delta and United. So far 2016 has seen only a $1.0 billion issuance by American Airlines, with other offerings expected.
A few developments are notable. First, advocates of the benefits of the Cape Town Convention and the related aircraft protocol,1 as well as market observers predicting more non-U.S. EETC issuance, were cheered to see that four of the 2015 offerings were by non-U.S. carriers and relied on the remedial provisions of the Cape Town Convention and the aircraft protocol.
Second, several offerings did not use the prefunding structure customarily used in the market. Instead of prefunding future aircraft deliveries, Delta, American and United all refinanced recently purchased aircraft, in each case targeting an efficient pricing to lower the airline's average cost of debt.
Third, an important structural innovation was made to EETCs in 2015. A new "super-senior" class of certificates styled as "Class AA" with underlying equipment notes styled as "Series AA" was introduced. These Class AA certificates are characterized by a senior-most position in the payments waterfall as compared to the other classes of certificates (with the customary exception prioritizing adjusted interest on junior classes ahead of principal distributions on the more senior class) and a comparatively lower initial LTV ratio2 than the range customarily used for structuring Class A certificates. Class AA certificates to date were generally structured to have LTVs just under 40%. These characteristics, along with the other structural enhancements typical to EETCs, allowed Class AA Certificates to obtain AA credit ratings. The Class AA offerings generally were structured with weighted-average lives of nine years or so and achieved coupons ranging from 3.45% to 3.75%.
In the unsecured bond market, aircraft lessors and airlines were active. Lessors issued nearly $6 billion of notes in the U.S. markets since the start of 2015. AerCap, having completed its acquisition of ILFC in 2014, came to market in June and October of 2015 for an aggregate of $2 billion of gross proceeds. Air Lease Corp released $600 million five-year notes in April and in 2015 sold $1.1 billion in notes in offerings in January and August. Aviation Capital Group sold $900 million of notes in September. Aircastle recently returned to market to take advantage of tighter credit spreads. The proceeds of these offerings are being used for general corporate purposes, aircraft purchases and refinancing existing debt. Lessors tend to like this market for its pricing, depth and flexibility in term. New bonds have been issued with tenors ranging from three to ten years, with many deals structured as seven-year bullets.
Among airlines, LATAM Airlines Group came to market for the first time since LAN's association with TAM. American and Virgin Australia returned to the market. Much of the airlines' issuance has been driven by the strategy of driving down their average cost of debt and diversifying funding sources. In the business jet space, VistaJet came to market with its first unsecured offering—$300 million of high-yield notes with a five-year tenor.
The aircraft ABS market experienced record volume in 2015 that was 50% greater than 2014 and was one of the most active periods in the market's history. In 2015, more than $4 billion of these ABS debt securities were issued, financing more than 200 aircraft. The market welcomed first-time offerings sponsored by DVB/Deucalion, Element, AWAS and BOC Aviation and a second offering by Castlelake, which had the distinction of being the first combined aircraft and engine ABS offering. To date in 2016, Apollo Aviation Group completed its second aircraft securitization, which issued $510 million of notes backed by a fleet of 32 aircraft.
One of the notable developments in this market was the shift to the Rule 144A/Reg. S institutional investor capital markets instead of the syndicated loan market to issue the debt. This shift was driven largely by comparative pricing opportunities.
One other notable trend during this period has been that third-party investors bought most or all of the equity in many deals. Our shareholders Adam R. Beringer and Geoffrey R. Kass published an article in our previous GTF newsletter examining aspects of this trend, particularly efforts by many e-note buyers to seek additional control rights.3
Finally, new issuance in the U.S. market for ECA-backed debt securities related to aircraft has been comparatively light. A handful of offerings guaranteed by the U.S. Export-Import Bank were completed during this period. The lapse in Ex-Im Bank's authorization in mid-2015 brought an end to the approval of new guarantees and, although the bank has been reauthorized, its board has three empty seats. Until one additional board member is confirmed by the Senate, Ex-Im Bank will lack the quorum to approve new guarantees greater than $10 million, such as for aircraft exports.
The outlook for the next 12 months of aviation debt capital markets issuance continues to be optimistic, with market expectations focused on increased aircraft ABS and lessor unsecured bond activity. We expect the private placement of secured debt securities, particularly EETC-like structures, may also see increased activity.
On the regulatory front, new rules under the U.S. Securities Exchange Act of 1934 related to credit risk retention and asset-backed securities developed pursuant to the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) are scheduled to come into force on December 24, 2016. The rules generally require a sponsor to retain at least 5% of the credit risk of the assets collateralizing a securitization transaction. The rules will apply to all new asset-backed securities offered and sold after the effective date, regardless of whether or not the securities offering is registered with the SEC, unless an exemption is available. As a result, these rules may influence decision-making by some aircraft lessors and other sponsors of new aircraft ABS, particularly those looking to sell all of their equity interest in the aircraft or engines that are being deposited into the structure.