As orders for new aircraft reach unprecedented levels, tight liquidity and a tough regulatory backdrop could pose challenges to airlines looking for financing at a competitive rate. Eleanor Wragg reports.
As the world’s ageing fleets are replaced with new, fuel-efficient aircraft, and airlines in emerging markets start to place hefty orders for the first time, there is growing concern about the aviation industry’s ability to meet its funding needs in today’s tough economic environment.
Aircraft manufacturer Boeing predicts that worldwide commercial aircraft delivery financing is set to rise to US$104bn this year, up from US$95bn in 2012. This looks to be an upward trend: Boeing sees this figure increasing yet further, to US$132bn, in 2017.
This step up comes both from a shift in established markets toward new, less fuel-hungry aircraft, as well as strong demand in the emerging markets driven by an increasingly affluent middle class. As a result, manufacturers are booking headline-grabbing orders such as that for 234 medium-haul jets placed with Airbus by Indonesia’s Lion Air – worth an eye-watering US$24bn – and Ryanair’s 175 single-aisle Boeing 737 order, valued
However, a perfect storm of headwinds – from the European sovereign debt crisis, the ongoing global economic uncertainty, the consequences of new regulations such as Basel III, as well as the impact of the 2011 Aircraft Sector Understanding (ASU) agreement which took effect at the beginning of the year – may make orders like these more difficult to finance, and by extension, more expensive.
In a January research report, Neil Hampson, PwC’s global head of aerospace and defence, sounded the alarm: “Our research highlights that whilst financing will be available, it will be at a higher price. As competition to secure financing intensifies, the question remains as to who will be picking up the cost.”
European banks, once familiar faces in the aviation financing space, have all but retreated from the market due to the cloud of economic uncertainty still hovering around them. That said, Aercap CEO Aengus Kelly points out that the Europeans are still in the market, although not to the same extent as before: “I wouldn’t underestimate them, although they’re much more selective in who they lend to.”
And who they lend to may be surprising – February saw tiny Air Pacific, Fiji’s national carrier, secure export credit financing from German-based KfW Ipex-Bank and Helaba for three new A330-200 aircraft, albeit in a UK Export Finance-backed deal.
Kelly also points to new entrants into the space: “We’re seeing new money from Singapore, Taiwan, China and Australia, and more importantly the US. The capital markets are more open and the big US banks and the investment banks are putting a lot of money in.”
“The capital markets are certainly becoming much more active again.
It’s a matter of bringing to the investors these kinds of deals in the right format. There is certainly big investor appetite out there, which is increasing,” says Jeremy Shaw, global head of export finance and regional head of trade finance for Emea at JP Morgan.
So far, rather than being in a state of crisis, aviation financing is in a state of flux, with new players and new models starting to be developed to help the industry meet its ever-growing financing needs. However, there is still uncertainty about where the financing will actually come from. Gordon Welsh, head of underwriting at UK Export Finance (UKEF) for the aviation sector, explains: “Basel III is still in the mix and people are still very much readjusting their balance sheets from previous crises. The insurance market is interested in chasing the yield on our loans, but hasn’t really got going in terms of doing loan deals yet, but that’s coming.”
“We see 2013 as being a part of a transition period,” adds Bob Morin, vice-president of transportation at the Export-Import Bank of the United States (US Exim). “There’s a change that is taking place in the industry in terms of how aircraft had been financed in the past and how they will be financed in the future. A lot of time is being spent on developing new products and new investors to finance the significant number of aircraft that are going to be delivered over the next several years.”
One major change in the sector happened at the beginning of this year, when Middle Eastern airline Emirates issued a US$187.1mn bond, backed by Coface, to finance the delivery of one A380-800. This represented the beginning of a trend of European capital markets being tapped to help fund export finance loans. While a European ECA did something similar back in 2010, when Britain’s ECGD (now UKEF) backed a bond issued by Aercap for the purchase of an Airbus aircraft, the Coface-backed deal is the first-ever rated ECA transaction. This rating – by Fitch – increased the number of investors who were willing and able to look at this ECA-guaranteed product.
Bonds backed by US Exim guarantees for the purchase of Boeing aircraft have long been a feature of the US market. Now market participants are optimistic that the Emirates deal will be a model that will take off in Europe for the purchase of Airbus aircraft, helping diversify the investor base while mitigating risks, and allowing borrowers to raise funds at a time when traditional financiers are less keen to take risks.
Yet another change in the sector stems from the new Aircraft Sector Understanding (ASU), which came into effect at the beginning of this year. It was designed to make ECA financing less advantageous for borrowers who can more readily access commercial financing, but the jury is still out as to whether the pact has had the desired effect.
Mark Lapidus, managing director of asset finance company Doric, says: “We see ECA financing as competition to us. It’s very much a welcome change that there is an increase in the cost of ECA financing, because it is impossible to be an aviation financing business where the aircraft can be delivered using ECA financing which is far cheaper than any other commercial alternatives.” However, so far, it looks as if ECA financing still offers a convincing alternative: “Even with the new ASU rules, ECA financing provides very attractive pricing so we still see it as a potential issue,” he adds. And indeed, for the ECAs, it’s business as usual.
“The backdrop is that the manufacturers are producing more aircraft each year. The percentage of that delivery by ECAs hasn’t varied very much,” says Welsh. “The market has not yet taken a different tack; the introduction of higher premium rates is not affecting at this stage the appetite for operating lessors or airlines to come to the ECAs. We are still seeing a lot of activity and I think if we were not as disciplined as we are, then people would want more support than we are currently offering.”
“Ownership costs of an airplane aren’t that big at the moment,” points out Aercap’s Kelly. “The fact that the spread has gone up on Exim or ECA will not change an airline’s behaviour; it’s not a big enough driver. What would change behaviour dramatically is if the Exims and ECAs said that they were going to materially reduce the amount of funds they will advance on each aircraft for all airlines. A bit of an increase on the margins is just noise.”
Today, airlines are looking to have a balanced book related to aircraft purchases, which includes a combination of leasing, on-balance sheet, off-balance sheet and direct commercial lending. “The ECAs will continue to play an important role,” says JP Morgan’s Shaw, adding that corporates are looking at their banking relationships and their funding options, and deciding to diversify and broaden these. “The good news is there are a lot of options out there, although the danger is that one option looks way too attractive compared to others and everybody piles in and then that starts to become unsustainable. Airlines need to take a very broad-based approach.”
UKEF’s Welsh says that banks are still relatively reluctant to lend over the long term. “They’re making offers but with a view to switch to a capital markets alternative and we are perfectly happy to support that.” Banks are also being pressured to charge smaller margins because of the growth, depth and competitive pricing of the capital markets. “Capital markets have doubled aviation financing from 5% to 10% in 2012 while ECAs have recently experienced a surge of guaranteed capital market offerings,” says Barbara Griffiths, EAF aviation finance team head at Citi Transaction Services, adding that this is a result of low interest rates and the increased comfort level of institutional investors with this asset class. “Meanwhile, commercial banks who typically lent under these ECA guarantees are now primarily focusing on core clients, as their balance sheet is impacted by new regulatory requirements and the cost of funding.”
ECAs have often relied on commercial banks to fund loans used to support commercial aircraft-related financing. While many banks are challenged by the lack of funding availability, aviation financing provides the prospect of earning spreads that banks could never get from corporate loans, and so remains a very attractive proposition to those who have the liquidity. “Some banks pulled back last year because of their liquidity problems, but quite a few are coming back again. The banking appetite for aircraft assets is stronger than it was last year,” says Doric’s Lapidus.
“There are more competitors entering, there are some new entrants and some people who are coming back in,” adds JP Morgan’s Shaw. “In my view that it is probably good news for the airlines but from a banking perspective I think it’s becoming increasingly competitive.”
According to Boeing’s current aircraft finance market outlook, Japanese banks, which have been financing most of the deliveries at home, are now returning to the global markets. Australian and Middle East banks are growing their share of regional aircraft financing, while a number of North American banks are also starting to finance lessors using their balance sheets.
Despite what at first glance appear to be some serious stumbling blocks for the future of aviation financing, strong underlying demand and the good health of the sector mean it is fiercely resilient. Boeing and Airbus forecast financing needs will be met in 2013, and there are few concerns, barring a catastrophic global economic event, that there will be a funding gap. Economic growth in Latin America, Africa, Asia and the Middle East accounts for many of the backlog of aircraft orders, and aviation is currently growing at a rate higher than the global GDP growth.
“Aircraft continue to become much more efficient, and much more technically advanced,” concludes JP Morgan’s Shaw. “Having the most up-to-date aircraft is becoming more and more important to airlines in an increasingly competitive industry with rising fuel costs. We see airlines looking to increase and upgrade their fleets at ever-increasing rates.”
For the banks, this means bigger-sized tickets and bigger deals. And as the world economy becomes ever-so-slightly more bullish, and air travel increases, the aircraft sector looks to remain a very attractive option.