Variations in features mean not all aircraft ABS are equal

In a detailed review of the aircraft asset-backed securities market over the past five years, S&P Global Ratings notes that some ABS investors are concerned that the current generation of A320 family and B737NG aircraft will follow the same path as the older vintage A320s and B737 classics, whose values were hit hard in 2001. The S&P leads on the report were Jing Xie, Director, Structured Credit Ratings and Betsy Snyder, Director, Corporate Ratings.

'In our surveillance on pre-911 aircraft ABS transactions (version 1.0), we observed that older vintages of A320s equipped with less desirable engines (V2500-A1 and CFM56-5A1) and B737-300s/-400s/-500s suffered higher-than-expected declines in values after September 11, 2001 and such value decline is permanent, raising a concern over the value retention risk of the current generation of aircraft,' it stated.

Addressing these concerns, S&P says a number of points are worth noting. 'The permanent value impairment on B737 classics was a result of both weak travel demand following Sept. 11, 2001, and high fuel price.' Furthermore, the B737NG has three times the installed base of the B737 classics, and A320ceo has a similar situation.
It also observes that while both Airbus and Boeing are striving to increase their production rates of neo and max, it will take them many years to fulfill their existing order book. Boeing has projected that about half of the A320 and B737 market will be occupied by neo and MAX by around 2026 and it will take even longer to replace all the current generation aircraft. 'Therefore, we see the new technology aircraft as moderate threats to the value of current generation aircraft,' it says.

The rating agency also remarks on significant changes that have taken place in the aircraft ABS market in recent years and the consequent impact on lease rates. ?'We have seen a significant amount of Asian money pouring into the aviation sector (both for airlines and aircraft lessors) in the past five years. We also see sizeable capital investments from business development companies and private equity.

'Many of these investors have started their own leasing platforms and compete due to the low costs of capital. Competition has created downward pressure on the lease rates and, to some extent, has influenced the discipline of lease term negotiation. For example, terms on return condition, which have a significant affect on the long-term value retention of aircraft, could result in lower standards.'

It says that although the lease rate factor in S&P Global Ratings' aircraft ABS transactions at closing usually ranges between 0.95 per cent and 1.1 per cent, which seems to be much higher than the LRF in the spot market, these LRFs are somewhat inflated because they are calculated as the quotient of the lease rental that was entered into when the lease was signed a few years earlier and the current depreciated aircraft value. 'If a re-leasing event occurs now, the LRF calculated as the quotient of current market lease rental and current depreciated aircraft value can be lower,' it points out.

It also discusses the ability of new leasing platforms to withstand an economic downturn given the commercial aviation industry's highly cyclical nature. 'Given that commercial aviation is a highly cyclical industry, new leasing platforms' ability to weather an economic downturn is a concern. Are they equipped to handle a downturn, or will they encounter financial difficulties and be forced to sell aircraft at low prices, thereby potentially negatively affecting lease rates and residual values for the entire industry?' it asks rhetorically.

Its answer: 'It is reasonable to expect that some weaker platforms could get into trouble in an industry downturn, though it's difficult to predict when that downturn will arrive. In our analysis, we differentiate between newer and more experienced servicers based on our view of their servicing capability and incorporate that view in our assumptions on lease rate decline and aircraft value decline.'

S&P said that post-GFC aircraft ABS transactions (which it refers to as 'version 3.0') started with young Airbus A320 and Boeing B737NG portfolios and have gradually shifted to primarily mid-life and older Airbus and Boeing commercial passenger aircraft portfolios. 'Although the majority of portfolios still comprise mid-life A320 and B737NG aircraft, some portfolios have significant exposure to out-of-production models or wide-body aircrafts. The market has also seen portfolios backed by regional jets, helicopters, turboprops, and business jets.

Explaining why so many aircraft ABS involve mid-life aircraft the rating agency says that against a background of healthy global air traffic growth, low fuel prices and some neo/MAX delays due to engine problems, demand for current generation A320 and B737NG aircraft has been high. 'With an abundance of capital chasing aircraft assets, it can be a good time to sell mid-life and older aircraft. Many lessors view ABS as an efficient way to sell a portfolio of mid-life and older aircraft to keep the remaining aircraft portfolio young and manage airline concentration.

'There are also some lessors (such as Castlelake, Apollo Aviation, and Aergen) that specialize in servicing and monetizing mid- to end-of-life aircraft, and they usually view ABS as a key financing instrument. Since mid-life aircraft often have higher value volatility, require more frequent maintenance, have shorter lease maturities, and are leased to smaller or less creditworthy airlines, managing these aircraft requires specialized knowledge, experience, and resources.

S&P also remarks on changes in the structural features of ABS transactions over the past five years. 'A typical version 3.0 aircraft ABS transaction has a scheduled amortization with an expected refinance date at the end of year seven. Over the past five years, a few new structural features have been introduced to many version 3.0 transactions - most are credit positives.

'These include end-of-lease payments (if not used for maintenance) being allocated to both debtholders and equity investors, one single pre-event of default (EOD) payment priority (rather than separate payment priority for aircraft disposition proceeds), maintenance reserve look-forward mechanism, and partial/full cash sweep. These features can help mitigate the risk of monetizing an aircraft's green time (or maintenance status) and the risk of higher-than-expected aircraft depreciation.'

On the other hand, new credit negative structural features include the issuer not keeping the initial security deposit under the initial leases, but being liable for repaying the security deposit at lease maturity, and the subordination of replenishing certain maintenance reserve accounts.

S&P said that although some capital market participants have been calling for a more standardized aircraft ABS structure, variances among various ABS transactions still remain. 'Examples include scheduled amortization speed, partial rapid amortization, maintenance reserve account(s)' look-forward sizing magnitude and priority in the payment priority, debt service coverage ratio calculation and threshold level, and one or two pre-EOD payment priority.'

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This article appeared in the July 12th 2018 issue