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Aircraft lessors provide compelling spread versus IG corporates

| October 11, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Finance Companies have topped the Bloomberg Barclays IG Corp Agg Index year-to-date with 6.18% excess return versus +3.39% for the Index, second only to Gaming (+6.87%) and Wirelines (+6.28%). BBB-rated Aircraft Lease company 7- to 10-year paper has produced excess returns of roughly 9-11%, with roughly 6-8% from 5-year paper.

Aircraft lease bonds outperformed as concerns about the fallout of safety issues with Boeing’s 737 Max aircraft have tempered over the past several months, and operators produced several quarters of strong operating results with good industry dynamics for growth going forward. For the lessors, subsequent cancellations of 737 Max orders are likely to be offset with new orders for similar, competing aircraft. Recent pricing pressures at major domestic airlines are offset by continuing strong demand for new aircraft and fleet needs of international carriers.

A snapshot of current spreads (Exhibit 1) show that IG aircraft lessors still offer yield/spread pick-up to the broader financial segment. Higher quality lessors, such as Air Lease (AL), offer roughly ~25-30 bp of spread pick-up to aggregate BBB Financials. Curves also offer good relative steepness in intermediate paper compared to most finance credits. Fundamentals are currently very constructive in the aircraft leasing industry, as backlogs remain robust and supply/demand dynamics are favorable to the financiers. Spreads have tightened sharply year-to-date, particularly since April as Boeing fears subsided (Exhibit 2).

Exhibit 1: IG Aircraft Lessors

Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

Air Lease (AL: BBB/BBB; KBRA A-)  is an industry bellwether, with the youngest fleet (average age <4 yrs), and one of the industry’s larger lease portfolios (~320 aircraft, with commitments for 343 more for $24 billion as of 2Q19). The Air Lease management team includes industry icons Steven Udvar-Hazy and CEO John Plueger, the former of which originally founded ILFC and more or less created the industry.

Spreads have tightened sharply year-to-date, particularly since April as Boeing fears subsided (Exhibit 2).

Exhibit  2: IG Aircraft Lessors – current spreads vs beginning of the year

Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

There is a unique opportunity in the market – a recent structured new issue from Avolon Holdings Ltd. that boasts IG credit with HY structure. The issuer is Global Air Lease Co. Ltd (GALC; new entity within Avolon Holdings Ltd), AVOL 6.50% 9/15/24 (5NC2, CUSIP: 37960JAA6) that has a senior AVOL rating of Baa3/BBB-/BBB- and a GLAC rating of Ba2/NR/NR. The 6.50% coupon has a PIK rate of 7.25%. AVOL 5NC2 PIK Toggle notes trade at roughly +450-500 bp to the curve, in-line with true HY issuers in the aircraft and commercial finance space (Exhibit 3).

Exhibit 3: IG and HY Aircraft Lessors / Commercial Finance

Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

Corporate structure

GALC is a newly formed entity that specifically holds Bohai Leasing’s 70% shareholder interest in the Company. Avolon was purchased by China-based Bohai Leasing Co Ltd in 2016 for $2.5 billion. Bohai is 51% majority-owned by Hong Kong-based and privately-held HNA Group. Late last year, Japanese commercial finance conglomerate ORIX Corp (ORIX: A3/A-/A-) bought a 30% equity stake with high voting rights in AVOL. The PIK Toggle notes are therefore considered structurally subordinated to the rest of the outstanding AVOL debt stack, due to the ownership relationship between Bohai versus the newer minority stake holder ORIX. The subordination, plus the PIK Toggle structure, account for the two-notch lower rating (Ba2) at Moody’s. The 5NC2 notes were issued in late July with the Paid-in-Kind Toggle feature, which enables the issuer to defer coupon payment until maturity at the higher “penalty” rate of 7.25%.

AVOL has one of the strongest aircraft portfolios in the industry, second only to AL. It is the second largest globally with 504 owned aircraft and 49 managed as of year-end. The company had commitments in place for 398 additional aircraft. AVOL boasts a very young fleet with an average age of 5.0 years – second only to AL among IG lessors. Remaining lease terms were 6.9 years on average as of 1Q19. The aircraft are 64% narrowbody and 36% widebody, with concentrations among popular models, such as the A320 CEO and NEO, the B737 NG and the A330. Exposure to the Boeing 737 MAX is currently only 6 aircraft, although it does account for 135 of the commitments. Their fleet is 58% Airbus and 37% Boeing. In the 1Q19, the company sold 20 of its aging aircraft (average age of 8 years).

No single airline accounts for over 5% of AVOL’s annual revenue, offering a diversified lessee base of 150 customers. Revenue is also diversified by geography with just over 50% from Asia Pacific, 26% in Europe/MENA and 22% in the Americas. To the extent there is residual/ongoing fallout from the Boeing 737 Max priced into the sector, that would present as an opportunity to add exposure; in short, there does not appear to be a high degree of risk from long-term cancellations in the program, and any near-term disruption will be offset by the potential leasing of alternative aircraft.

AVOL achieved investment grade ratings from all three rating agencies for the first time this year, when they issued the three-part $2.5 billion unsecured deal in April, using $1.2 billion of the proceeds to pay down secured debt and term out their debt profile. Unencumbered assets increased by $2.3 billion to $11 billion (of $27.5 billion total assets) as a result, offering a much more impressive base of assets that would be available to access for liquidity if necessary. Secured debt now makes up only 37% of total assets, which is a vast improvement to the liquidity profile, and instead has increased unsecured debt outstanding from $7.4 billion to over $12 billion including term loans. The company believes this leaves them with over $5 billion in available liquidity, including cash, restricted cash flows and undrawn secured debt. AVOL has negligible debt maturing prior to 2022, and a $2.5 billion revolver available until that year as well.

AVOL trades wide to the sector in part due to its foreign ownership, which means different reporting restrictions from other issuers in the segment. Avolon was purchased by China-based Bohai Leasing Co Ltd in 2016 for $2.5 billion. Bohai is 51% majority owned by Hong Kong-based and privately-held HNA Group. Given the current political unrest between the two regions, this creates a potential uncertainty with regard to AVOL; as well as the potentially opaque nature of  the ultimate equity parent company, although HNA Group does report public financials. Late last year, Japanese commercial finance conglomerate ORIX Corp (ORIX: A3/A-/A-) bought a 30% equity stake with high voting rights in AVOL. The investment came with a shareholder agreement with Bohai that stipulates among other things that AVOL be managed as an investment grade company, and that dividends cannot exceed 50% of net income. This arrangement helps mitigates the risks of the Bohai/HNA ownership.

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