By Alok Wadhawan
In the current economic environment of low interest rates and economic uncertainty, the aviation sector can offer an attractive investment option to institutional investors.
Aircraft are expensive and airlines typically have low margins so prefer financing through operating leases or finance leases instead of paying cash for purchasing aircraft. Concurrently, in tough economic times and in a low interest rate environment, attractive yields have become harder to find. These economic circumstances have supported the growth of a $122 billion aircraft finance market and consequently caught the interest of a number of institutional investors for aviation financing.
Despite a tough decade, airlines have taken steady delivery of new aircraft over the last ten years. The current macro environment where the low price of oil fuel has driven up air passenger growth and buoyed airline earnings and demand for aircraft, has made new aircraft an even more viable prospect. This supportive environment has encouraged an increasing number of institutional investors such as insurance companies, pension funds, sovereign wealth funds and certain private equity funds to look into aircraft finance for better returns.
Absolute return backed by hard asset
With a benchmark return of between three and four per cent after costs on senior debt, aircraft financing already represents an attractive product for institutional investors today, but it also has other advantages that deserve consideration.
Aircraft are typically a dollar asset, which is an attractive aspect for investors looking for a good opportunity to get USD exposure in a stable asset class. Aircraft finance deploys large amounts of capital efficiently, delivers predictable returns and is a highly mobile asset which helps with reclaiming and deploying the asset in case of a default.
The aircraft- the underlying asset- is truly global in its recognition and usage, and because the loan is backed by a real and fairly liquid asset investors have the opportunity to realise the full value of their loan even in the case of a default.
Will there be turbulence?
A key risk with aircraft financing is the rate at which the asset’s residual value deteriorates with age. But crucially, in spite of the loss of value, investor loan to value improves over time as the loan repayment is quicker than asset depreciation. The strong value retention and liquidity of aircraft, especially the new models being produced today, support high levels of leverage, historically as much as 80% of an aircraft’s Market Value, which, along with cost of borrowing, is a key driver of enhanced equity returns.
Another risk is physical security of the asset, if the aircraft is operated and / or registered in a jurisdiction where the legal framework is not sound. However, aircraft equipment (defined as aircraft and aircraft engines) is protected by the Cape Town Treaty, an international treaty to which most countries in the world have signed up to and is intended to standardise transactions involving moveable property and provide a robust framework for aircraft recovery.
And of course, the financial health of airlines must be a consideration for investors, though, as mentioned, with the low price of oil and rise in passenger numbers most are looking buoyant.
Further considerations for investors
An additional advantage for those who are investing in aircraft finance is that the learning curve for the establishment of relationships and technical expertise, as well as the documentation of operating leases and purchase transactions, helps to protect the aviation investment and finance industry from complete market overrun and structurally provides a limit to competitors.
Furthermore, for those investors governed by Solvency II, investing in a portfolio of secured aviation debt is also an opportunity to access investment grade rated assets, providing an additional incentive.
Far Eastern tailwinds
In the coming months and years, we expect to see the industry continue to stretch into new markets, particularly Asia and the Far East. China is to invest $11.9 billion in aviation infrastructure and new structures in 2016, resulting in increased interest from investors and greater efficiency for airlines and lessors.
Alok Wadhawan is co-head of Investec Aviation
