Aircraft securitization cleared for take-off.

AuthorRendall, Allison

Since the first aircraft asset-backed security (ABS) came to market in 1992, the market has grown to more than $17.4 billion in public, private and international securitizations as of August 2000 (Exhibit 1). Since its introduction, aircraft ABS has grown at a 41.2% compound annual growth rate (CAGR). The number of aircraft securitizations, which has averaged just two transactions a year since 1996, may increase to more than three times that number in 2000. As an emerging asset class, aircraft ABS enjoy a growing awareness in the ABS investor community, supported by expanded ABS research and secondary market liquidity. Fundamental to aircraft ABS is the ability to model a transaction to attract investment-grade and high-yield investors to securities with ratings ranging from AA to BB. Aircraft ABS offer investors attractive spreads versus other ABS, a phenomenon that will likely diminish as the sector grows.

Investor consideration is being driven by demonstrative pool performance, increasing disclosure regarding collateral quality and innovative structures. Investors can now more easily differentiate between transactions, deal sponsors and servicers. Credit spreads are expected to converge around loan-to-value (LTV) ratios consistent with assigned ratings.

  1. INTRODUCTION

    Since the first aircraft asset-backed security (ABS) came to market in 1992, the market has grown to more than $17.4 billion in public, private and international securitizations as of August 2000 (Exhibit 1). Since its introduction, aircraft ABS has grown at a 41.2% compound annual growth rate (CAGR). The number of aircraft securitizations, which has averaged just two transactions a year since 1996, may increase to more than three times that number in 2000. Five deals have already been brought to market this year (Exhibit 1). As an emerging asset class, aircraft ABS enjoy a growing awareness in the ABS investor community, supported by expanded ABS research and secondary market liquidity. Fundamental to aircraft ABS is the ability to model a transaction to attract investment-grade and high-yield investors to securities with ratings ranging from AA to RB. Aircraft ABS offer investors attractive spreads versus other ABS, a phenomenon that will likely diminish as the sector grows.

    Investor consideration is being driven by demonstrative pool performance, increasing disclosure regarding collateral quality and innovative structures. Investors can now more easily differentiate between transactions, deal sponsors and servicers. Credit spreads are expected to converge around loan-to-value (LTV) ratios consistent with assigned ratings.

    The key elements of an aircraft securitization are 1) deal sponsorship, 2) the servicer, 3) the collateral backing the securities and 4) lessee credits. Because each aircraft type represents a significant capital investment, the servicer's ability to maximize future cash flows earned from the aircraft and minimize losses is critical to portfolio performance. Losses, expressed through bad-debt expense, and reduced lease rates can arise from either remarketing events associated with defaulted leases or off-lease aircraft.

    Of the transactions that have entered the market, the number of aircraft in a portfolio ranges from 11 to 229. An average portfolio includes 25-35 aircraft. Due to the value of each asset, with the range of appraised value for a single aircraft of $5 million-$70 million or more, an understanding of the difference between the more accepted traditional leasing assets and those that are less liquid is essential. A few less liquid aircraft in a portfolio, given the capital-intensive nature of these assets, could reduce initial overcollateralization or cause losses on the rated subordination tranches of a transaction.

    1. Why the Growing Need for Securitizations?

      The Boeing Co. predicts more than $1.5 trillion in new aircraft will be delivered over the next 20 years. Background supports the predictability of aircraft demand based on the same degree of long-term predictable traffic growth driven by growth in the gross domestic product (GDP). Traffic growth is the most significant factor driving manufacturing, airline operations and financing needs.

      Securitization provides a reliable, long-term flexible source of aircraft funding for this cyclical industry. In addition, the use of the capital markets brings a wider universe of investors whose diversity and breadth of investment appetite meet the aircraft finance market's continuous need for capital.

    2. Trend toward Operating Leasing

      The trend toward operating leasing is propelling an increase in aircraft ABS transactions. An operating lessor can reduce its risk by diversifying its portfolio across equipment type and lessees while raising long-term debt financing through securitization. This diversification allows for the efficient matching of long-term assets and liabilities. Such diversified pools of equipment and lessees are the foundation of aircraft ABS.

      The number of leased aircraft in commercial fleets (including finance leases) rose t 43.4% in 1998. The proportion of operating leases in airline fleets is predicted to grow from the current level of 25% to 35% as early as 2006. Although this trend reflects growth in passenger traffic in developing markets such as Asia and Latin America, it also mirrors the use of operating leases by strong and secondary carriers in developed and developing markets.

  2. SECURITY DYNAMICS

    The leading contributors to a reduction in cash flow in any aircraft ABS transation are a reduction in the value of the aircraft, reduced lease rates and increased aircraft remarketing time following a lessee delinquency or lease expiry. The credit quality of the lessee pool in an aircraft portfolio will drive varying rates of default frequency and require either more frequent releasing events or the restructuring of contractual cash flows. Thus, to a large extent, liquid collateral allows lessors to rely on rapid aircraft redeployment following a default or lease expiry. However, during a severe economic downturn it can still be difficult for a lessor to remarket even the most liquid aircraft to a new lessee. Indeed, the remarketing time on liquid aircraft increases to 30 days on average during an economic downturn from 10 days under normal market conditions. By contrast, a lessor may need to lease a less liquid aircraft to a weaker credit or, in many cases, a riskier start-up carrier if the aircraft is to be moved at all.

    1. Factors Driving the Repayment of Aircraft ABS

      An analysis of aircraft ABS begins with the following factors:

      * Asset resilience and transferability. Aircraft ABS focus on liquid aircraft types with a low risk of technological obsolescence and a large and diversified installed operator base.

      * Portfolio diversification. Due to the capital-intensive nature of this asset class, it is important to reduce the risks associated with the default of one or more lessees.

      * Servicer's market breadth and financial strength. The operational capability and experience of the servicer should be reflected in any managed aircraft portfolio. Long-term viability through direct or indirect financial condition (backing) must be evident.

    2. Evolution of Aircraft ABS Analytics

      The market's analysis of aircraft ABS transactions is still evolving. There has been a steady though noticeable shift in the evaluation of collateral, lessees and servicers by rating agencies and investors. The drivers behind each of the principal risk components increasingly being explored include:

      * Individual aircraft (narrowbody/widebody, user base, age [in certain cases, the number of cycles], technology, engine, appraised value, maintenance condition and year of production)

      * Current market volatility or lease rate volatility

      * Residual performance of individual aircraft and the portfolios

      * Lessee exposure

      * Credit quality and servicer risk

    3. Aircraft Specifications

      When the aircraft ABS market commenced in 1996, the focus was principally on the mix between narrowbody and widebody and Stage II versus Stage III. Today, these issues are complemented by the analysis of an installed base, the number of aircraft in service and the number of operators. Also analyzed is whether the aircraft is part of a family of aircraft that shares common operating and maintenance features, which provide efficiencies to the airline.

      When considering a portfolio, a macroanalysis of pool composition is necessary. Given that each asset in an aircraft portfolio is capital-intensive, an evaluation of two similar-sized portfolios, one of which has less desirable aircraft types, whether by number of less liquid narrowbody aircraft or widebody types, shows the same level of leverage cannot be sustained at the targeted rating level. This is particularly true for small niche lessors of smaller securitized portfolios. Here, the lessor's portfolio of clients may be too small to remarket a widebody quickly. The smaller securitized pool's performance can be adversely affected by a single widebody type or weaker narrowbody types.

      All else being equal (lessee concentrations commensurate with credit risk), a portfolio comprising less volatile, highly liquid modern technology narrowbody aircraft--a mainstream aircraft--should produce a more sustainable stream of cash flows compared with a portfolio evenly split between a more volatile mix of widebodies and high-demand narrowbodies. Portfolios can be evaluated based on a distribution of residual performance across a 25-year horizon to compare likely portfolio performance.

      The greater volatility of weaker narrowbody types or widebodies can only be mitigated through increasing portfolio size and obtaining a more experienced servicer. A lessor or servicer should have demonstrative experience in managing widebody aircraft. For example, known managers capable of efficiently managing widebody aircraft are mega-lessors GE Capital Aviation Services...

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