We take a look at the nuanced and previously untested ABS facility amid continued uncertainty for the airline industry’s prospects in 2021. Tim O’Connell and Andy Charters look at some key considerations for ABS servicers, noteholders and other stakeholders.
A second peak in COVID-19 cases in Europe and the USA, and the subsequent travel restrictions it induces, has created further pressure on the airline industry. This is expected to lead to additional lease deferrals, airline defaults, lower aircraft demand and value impairments.
While leisure travel might be expected to pick up as the vaccination programmes take effect, there is an increasing awareness that the summer tourist season will not be able to run as normal, given current high infection rates and the different speeds of vaccine roll-outs across the globe.
Further, it's likely that airlines will continue to struggle with weak demand for business travel throughout 2021 and beyond. A recent survey revealed that many CFOs who control company budgets don’t see business travel ever returning to pre-coronavirus levels. This is significant, given that business travel has historically generated as much as 50-75% of carriers’ profits.
Industry pressures lead to stress within aviation ABS structures
Deteriorating airline credit, lease deferrals, lease-term renegotiations to ‘power-by-hour’ type clauses and downward pressure on aircraft values all negatively impact aviation asset backed securities structures. Reduced cash flows due to falling rental income has led many ABS transactions to breach cash-trap or rapid amortization triggers. For example, the Metal 2017-1 series ABS received USD 858,000 in monthly rental income in October 2020, compared to USD 5.7 million in October 2018.
As a result, many ABS structures have been downgraded. Fitch has downgraded approximately 40% of its aviation ABS portfolio. Many remain on Rating Watch Negative, and Fitch has warned that there may be further downgrades to come. Institutional investors that are barred from holding sub-investment grade notes may, therefore, be forced to sell.
Spotlight on the maintenance reserve account
In this environment, careful analysis of the maintenance reserve account funding is required. Although some maintenance expenses will be reduced due to lower aircraft utilisation, there are still significant costs that are time driven.
There are also additional support costs that may not have been modelled if an aircraft comes off lease and control is handed back to the servicer, including:
collation of records
preparation for storage.
How long can an ABS structure operate with inadequately funded maintenance expense accounts, which will drain liquidity reserves?
According to a recent article by the International Bureau of Aviation, ABS 'events of default' are most likely to occur in the medium term due to maintenance versus provision mismatches. However, we think stakeholders need to be taking note of this risk now.
ABS cash flows in a distressed environment
In theory, the ABS should explicitly set out the priority under the waterfall for every eventuality. In reality, we have seen that there is a level of subjectivity in distressed situations.
For example, calls need to be made as to what constitutes an expense that will take priority over A Note interest, should an asset be sold.
In buoyant economic times, the relationship between noteholders and servicer, and as between the different classes of noteholders, is straightforward. But in times of stress, those dynamics can come under pressure.
There is scope for interpretation, leading to potential disagreements between classes of creditors. For example, what types of cash flow should feed into the senior reserve as a primary expense ahead of interest payments to A and B noteholders, so as to keep aircraft flying?
Further, there could be the potential for a conflict of interest between a servicer and noteholders, not least where there are inter-creditor disagreements.
Servicers or noteholders may, therefore, consider obtaining independent support with cash flow modelling, as this will provide an independent and objective view that can help facilitate greater trust and transparency, both as between the servicer and noteholders, and during inter-creditor discussions.
The role of the servicer is vital
In a steady market, the credit worthiness of an ABS structure is measured by its lessees and asset composition. When times are difficult, the strength and experience of the servicer can make the difference between a successful outcome or serious consequences for all stakeholders.
Servicers need to make carefully balanced decisions, considering the extra-ordinary pressures on airline lessees and aircraft assets, as well as noteholder requirements. While servicers are used to modelling future revenues and cash flows, they may not always have the relevant restructuring experience or expertise when assessing potential outcomes of different options through a ‘distressed’ lens.
The ability to build confidence with stakeholders during financial stress is critical. Those servicers that have access to the relevant advice and experience to foster informed decision making and navigate this period of distress could make the difference between ABS structures surviving or not.