Storm clouds are gathering in the world of aircraft finance as crucial ECA financing is set to become more expensive, writes Sarah Rundell.
Although the effects won’t be felt for another year, the new aircraft sector understanding (ASU) agreement is likely to increase the cost of export credit agency (ECA)-backed funding.
The 2011 ASU, which supersedes the 2007 version, sets out revised pricing terms and conditions for ECA funding which are far more onerous with more costly lending, higher fees and a maximum 12-year repayment term, except in exceptional cases. It comes as the economic environment looks more challenging once again and banks brace themselves for additional regulatory burdens under Basel III. Experts say there are already more deals to finance than banks to finance them, and the worry is that smaller operators, priced out of the capital markets and having to pay more for ECA loan guarantees, will struggle to access finance. Far-sighted borrowers are mulling new sources of finance in anticipation of the squeeze.
New financing terms
From the end of 2012, borrowers will pay almost double for ECA guarantees on their debt in line with the ASU’s underlying goal to make this market comparable with the costs and conditions in the commercial loan market.
“The new ASU arrangement makes ECA-backed funding more expensive across the board for all airlines, irrespective of their rating,” says Valentino Gallo, Citi’s global manager for structured trade finance.
The latest swathe of deals shows how important ECAs are in keeping the pipeline flowing. Recent months have seen Royal Air Maroc finance four new aircraft through a 12-year ECA
loan facility co-insured by France’s Coface and Italy’s Sace. Air China recently won European ECA-backing for six aircraft in a landmark deal. And leasing company Aircastle secured approvals of up to US$530mn of debt financing supported by Coface.
It’s a role ECAs carved out during the downturn. As banks cut back, the US Export- Import Bank (US Exim), the UK’s Export Credits Guarantee Department (ECGD), France’s Coface and Germany’s Hermes stepped up their support of transactions to the industry. ECA support reached US$21bn in 2009, equal to an estimated one-third of the total value of all aircraft manufacturers’ Boeing and Airbus deliveries and almost double the level seen in 2008.
“They have successfully supported a significant proportion of the major manufacturers’ deliveries of aircraft over recent years, to the point where the ECAs and their guardian authorities have questioned whether the degree of reliance placed by airlines on the ECAs, and the concentration on aviation of the risks borne by the ECAs, are sustainable,” says Philip Lewis, director of HSBC’s structured asset finance team.
The issue came to a head around the so-called home market rule which prevented some airlines from accessing cheaper ECA financing. Airlines based in Boeing and Airbus’ domestic markets – those operating out of the US and France, Germany, the UK and Spain respectively – cannot tap ECA support. This means groups like British Airways, Air France, Lufthansa and all American carriers have had to rely on more expensive commercial funding, giving rivals in Canada and Australia, expanding Middle East operators and newcomers like Dublin-based Ryanair an advantage.
Ryanair finances roughly 60% of its deliveries using export credit structures. “It was debated whether the governments and ECAs supporting the Airbus and Boeing products are effectively disadvantaging their own domestic airlines which are not eligible for ECA financing, while a number of the leading competitors of those airlines can benefit from the financing schemes,” adds Lewis.
Increased ECA premiums will hit the market hard. In some cases entire fleets have been funded with ECA-backed structures. The challenge now is to alter their sources of debt. Some may not be able to finance all their purchases and this could be an issue for the manufacturers.
In developed markets, Dubai-based Emirates could become a test case, predicts one banker. Emirates has flourished on the back of cheap ECA-backed financing. Over the years its treasury has raised US$21.6bn via ECAs, operating leases, commercial asset-backed debt and non-conventional sources such as Islamic funding. The Dubai airline needs more than US$28bn up until 2017 to expand its fleet of Boeing and Airbus SAS jets in its bid to build a global network.
“This is a substantial amount,” says the banker. “Emirates tapped the ECA market often. It will be a test case as to whether they can diversify their funding. They have an excellent treasury; it will be interesting to see how they finance going forward.”
But it is the smaller, emerging market operators priced out of the capital markets that will really feel the draft. The hike in ECA guarantees will ultimately affect their cost base and ability to compete. “It is overall bad for the industry in that it dismantles an attractive source of financing,” says Citi’s Gallo.
Increased ECA premiums could also coincide with rising rates in the debt market. Bankers say it is a myth that more banks will rush to lend to the sector once ECAs increase the cost of their guarantees.
Some critics have blamed ECAs for the lack of commercial activity, arguing that the cheap financing their presence ensures has dulled banks’ enthusiasm for the sector. “ECAs are seen as complementary to the role of banks rather than antagonistic or competitive,” argues Gallo.
Moreover, Jeremy Shaw, head of global trade Emea at JP Morgan points out that ECAs have only been providing the guarantees. “It is not a question of banks lending more; banks have been providing the finance anyway,” he says.
Indeed, it appears that other factors are at play. There are now only around 10 banks with fully dedicated aviation desks and others come in to serve top tier names only. “Some banks like WestLB have pulled out, while others in the UK and Germany who used to be big players are not writing much new business,” says Michael Weiss, head of Investec’s aviation team in London.
“The market is already difficult given the pressure on the European sovereigns and its negative effects in the bank loan market,” says Citi’s Gallo. “When banks lend, the interest rate they quote reflects their funding costs; it has reduced from three years ago but is now in an upward trajectory again.”
Manufacturers won’t just be put under pressure if operators scale back orders. Increased ECA premiums will also improve the value of used aircraft in the secondary market. Values of older fleets were forced down by the cheaper cost of financing new aircraft but now the economic viability of the second-hand market should spike again. High oil prices however, will keep demand for new planes steady. “Old planes are more expensive to fly – like used cars,” counters Roger King at research group CreditSights in New York.
Smart operators are looking to diversify their funding away from costly bank debt. Leasing company AerCap’s sale of ECGD-backed bonds to finance six airbus aircraft is a case in point. “This was the first ever notes issuance for Airbus aircraft guaranteed by ECGD,” says Keith Helming, CFO of AerCap. “This transaction provided lower cost funding for us and established another new source of capital.”
ECGD supported this capital market transaction, stepping up from its usual role to guarantee bank debt and showing that ECAs are innovating too. “ECAs responded very strongly in the financial crisis to plug the gap in liquidity and they are now showing more flexibility, moving away from pure guarantees to funding other types of structures,” says Shaw at JP Morgan. “This has to be the way forward given the huge order book right up until 2029.”
Similarly, Ryanair closed the first euro-denominated US Exim-guaranteed bond for €156mn (US$222mn) in July. That said, the more innovative structures can come with a hitch. “Straight bank financing is bespoke,” argues Weiss at Investec. “You can negotiate on straight commercial debt financing, particularly if it is a relationship bank. ECA terms tend to be more rigid.”
Another trend could see manufacturers lend more to the sector. “Some may support some airlines on the short-term lending side, but this is not a long-term solution,” says JP Morgan’s Shaw. In previous downturns, Airbus has self-financed around 15% of deliveries compared to current levels of around 3%.
The commercial bond market, which disappeared during the crisis, is another potential source for the big players. “Bond holders are looking for stable assets through the volatility and planes perform well,” says Credit Sights’ King.
American Airlines’ brisk US$1bn issue earlier in the year, guaranteeing the notes with the company’s international routes, slots and gates, was indicative of healthy demand. Delta Airlines also went to the market with two high-yield rated alternative enhanced equipment trust certificates, secured by the company’s aircraft. The various collateral packages offer different types of security.
On one hand routes, slots and gates at “full” international airports like Heathrow are a valuable resource. Others argue they are intangible and don’t offer the same security as the physical asset of an aircraft. “The best collateral is a late model aircraft,” says King.
Observers caution that commercial opportunities remain limited. Investors “aren’t falling over themselves” to lend to the capital intensive industry. “Getting a business model that works in the industry is not easy,” says HSBC’s Lewis.
Success stories like Ryanair are unusual. Its minimal service, focused on the essentials, and young fleet that requires little maintenance is only suitable in certain circumstances. Other big carriers are less attractive to investors because of agreements with unions, outdated infrastructure or hubs far from Asia’s booming economies.
The affect of the ASU is still difficult to call. “There is substantial grandfathering and even grand-grandfathering transition mechanisms in place from the two previous sector understandings which will cover aircraft deliveries until 2013, or even later for some aircraft types,” says Michael Nosbuesch, head of aviation financing at Germany’s KfW. Nevertheless more expensive financing as the economic climate threatens to change again is preying on both lenders’ and borrowers’ minds.