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"The question is, will investors remain with the asset class as a diversification strategy, or will they move to alternative higher yield returns?"

If interest rates continue to rise, where to next for aircraft leasing?

09 Aug 2018

While investors are still comfortable with the status quo, forecasters are looking to alternatives to prepare for possible interest rate rises. Ocorian’s Corporate Services Manager Elaine Kennedy looks at some of those possibilities.

Recent conferences and industry chatter show the aviation finance industry is generally a happy lot. Though some worry we’re headed for another cyclical bubble situation, aviation leasing currently still provides a good return. There is change afoot, though; people are now questioning whether the cyclical nature of aircraft leasing has in fact been redefined.

The low interest environment has been a significant contributor to the growth of operating lease companies worldwide. Historically, lessors used their borrowing capacity for cheap, unsecured debt to fund deliveries of new aircraft, so the low cost of funding became a competitive advantage.

But, there’s a big “but”. If interest rates do continue to rise, the industry as we know it may start to lose cabin pressure. The cost of funding rises with rising interest rates and the question is, will investors remain with the asset class as a diversification strategy, or will they move to alternative higher yield returns?

What impact will higher interest rates have?

The industry cost of higher interest rates is more than just an increase in the cost of borrowing; it also decreases access to capital markets and creates downward pressure on aircraft values. We may see non-traditional investment players dropping out of the market - and while those less well-hedged, less well-funded lessors leave, the established “big boys” and airlines with better credit and US dollar reserves are more likely to be able to navigate the other higher interest rate issues.

At the Ishka Conference earlier this year, investors from the fixed income side, such as insurance firms, were interested in long-dated rated asset paper due to the new requirements under the Solvency II Directive.

There has also been a big interest in equity aviation funds. Investors were interested in the airline credit, while lessors were more interested in asset type. The consensus was that until returns in other asset classes increase, investors are still comfortable to invest in aviation - even with the currency risk for European investors, considering these are dollar assets.

Diversifying to higher yields options

So what about those interest rates? Most predict a rise is imminent, similar to the USD, and this could bring about higher rentals for airlines. Also, most lessors seek to hedge their interest rate risk by borrowing at fixed rates or passing interest rate risk onto the airline through a floating rate lease. If this happens, aircraft on existing fixed rate leases may lose value while higher interest rates and low oil prices may increase the residual value of used aircraft.

If interest rates do increase, investors may be faced with moving away from investing in traditional aircraft deals. This may see them diversifyinto other types of deals with higher yield returns such as equity aviation funds deals; borrowing at a fixed rate; passing the risk onto the airline via a floating rate lease; using end or mid-life aircraft in new deals or lease extensions, which means an increased bullet payment at the end for the investor; and engine leasing for small niche lessors.

The short of it is that, while airline leasing is a boom market right now, investors might not be able to afford deals if those interest rates go up. Attention is turning to used aircraft.

Possible new routes for aviation leasing

One option getting people excited is mid to end-life aircraft leasing; indeed, Ocorian works a lot in this space. As with any asset, brand new aircraft are incredibly expensive and there are, by necessity, complex legal issues surrounding what you can and can’t do with that aircraft. Many of the big airlines have an average fleet age of five years, while analysis by IBA shows the average age of commercial fleet is around 11 years.

But most aircraft will last 20-30 years if handled well. What happens to those aircraft once the big boys are done with them? In addition, airlines with weaker credit ratings will struggle to rent or buy new. Older fleet are often offloaded to lessors as they are more complex to deal with, and lessors are happy to take them as they know demand for midlife narrowbodies remains strong as second-tier airlines and private companies seek these assets.

Then there’s the used parts market. Hardly glamorous, but a used aircraft engine can be a very attractive leasing prospect for investors who are priced out of the new aircraft market. Engines can often have a lifespan that differs from the aircraft they power, and they are considered commercially separate assets. There is a massive market around aircraft engine leasing, and this can actually be more affordable for smaller airlines - and more attractive for investors worried about interest rates.

Will we reach this destination?

So while the aircraft leasing market remains robust and buoyant, some minds are turning as to how to hedge investments if the market turns. Interest rates are creeping slowly upwards at the moment and are yet to have a major impact on the sector. The big question remains: when will the rises become too significant to ignore?

Ocorian’s aircraft leasing team has many years’ experience in mid to end life aircraft and engine leasing structures; get in touch to discuss how they can help your investment needs.