By Shaniel Ramjee
With interest rates at record lows in the developed world, prospective returns from traditional bonds don’t look promising, forcing income-seeking investors to look elsewhere for a decent yield.
But multi-asset fund managers free to invest beyond mainstream stocks and bonds can offer investors access to higher yielding investments by providing asset-backed financing to the real economy.
And it’s largely thanks to one of the legacies of the financial crisis.
Since 2009, companies have found bank loans harder to come by. The banks that used to provide businesses with the finance to continue operations and expand, have become much more reticent about lending. This is because, in the wake of the financial crisis, regulators have forced banks to shed risk and hold much more capital in reserve. Banks may now be less likely to go bust in the next financial crisis, but an unintended side effect is corporates are finding themselves starved of capital.
Airlines, for instance, typically finance around half their fleet to better manage their balance sheets and when banks started lending less, and in many cases unwinding their aircraft financing operations, they were forced to look for alternative sources for the loans they needed. And because they were also now prepared to pay more for scarcer financing, the risk premium on providing the loans for new aircraft was sufficient to make this viable for investors.
In 2010 we entered the aircraft financing market for the first time, backing the purchase of an Airbus A380 aircraft – Airbus’ so-called super jumbo – to be operated on a 12-year lease by the airline Emirates. At a time of rock bottom interest rates, the annual yield on our investment was around 9.5% over those 12 years. And because the loan was backed by a real asset, we also had the opportunity to realise the residual value of the plane at the end of the period. This was the first of several such deals that we were involved in and these investments currently account for around 6% of our portfolio.
As with any kind of investment, the asset manager needs to fully understand the risks in order to assess whether the return on offer is a worthwhile compensation. A key risk with aircraft financing is the rate at which the asset’s residual value deteriorates with age. When we first entered aircraft financing, the A380 had only just come into production which meant its shelf life would most likely be long enough to suit our appetite for risk. It was a new design using the latest technology at a time when existing large hub-to-hub aircraft such as Boeing’s 747, a market leader for decades, were reaching the end of their useful life.
Because the A380 was new, there was no available data on how it depreciated but when we looked at other large aircraft like the 747, we found that you normally get between 40% and 60% depreciation over 12 years. But crucially, in spite of the loss of value, investors still have a claim on the real asset at the end of the period. And if an asset bought in 2010 is sold after a 12-year deal matures, it is priced in 2022 dollars so it can also be treated as a partial hedge against inflation. Obviously there is also a risk of losing the aircraft in an accident which is insured.
A growing number of asset managers are moving into aircraft financing and yields have started to come down as capital becomes more abundant. The most recent investment we made in this area priced at an 8.25% yield – still very attractive and nearly double the yield on an Emirates corporate bond, for example, but we think the interest rates on aircraft deals will continue to drop and probably fall below 8% at some point next year.
At that level, we would probably be less likely to participate in this type of investment. But the conditions that encouraged us to become involved in direct financing in the first place are likely to persist and we continue to look for new opportunities. There are other areas vacated by banks that present potential opportunities, such commercial property or productive land.
To date, while insurers are moving in on long-term government-backed loans in areas like infrastructure to cover liabilities associated with the pension products they sell, few fund companies have moved in on these shorter term deals providing direct financing to corporates and returns are still attractive
In time, of course, the window of opportunity will close. The banks will return, bond yields will rise and the returns on offer will not outpace the risks.
But for now, at least, the opportunities are out there for investors. Why should they lend to the government at 2% when we can get a much higher yield lending into the real economy?
Shaniel Ramjee is an investment manager at Pictet Asset Management
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