Leasing for Yield?

February 6, 2020

Source: Ascend and Boeing analysis; 2017, 2018: Ascend data only Source: Ascend and Boeing analysis; 2017, 2018: Ascend data only

Air travel has more than doubled over the past 15 years. The trend growth has proven resilient, only contracting three times in that period (following 9/11, and during the SARS outbreak in 2003 and global financial crisis between 2007 and 2009). Several factors have contributed to this trend, including the emergence of the global middle class, shifting consumer trends, an increase in the number of direct flights and the relative affordability of air travel. A 2019 report by trade group Airlines for America noted that between 1971 and 2018, airfare almost tripled — a modest increase when you consider that U.S. consumer prices rose by a factor of 6.2 and the cost of a day at the Magic Kingdom increased 31.4-fold during that same period. The small increase in the price of airline tickets can be attributed to a larger market share occupied by low-cost carriers, more efficient aircraft and efforts to cram more passengers into the same space at the expense of legroom. Boeing has forecasted that deliveries of 44,040 commercial aircraft, valued at $6.8 trillion, will be needed to meet demand between 2019 and 2038. With the growing need for aircraft, financing volume also increases.

This increase in financing volume presents an opportunity for investors. The opportunity is not new, but is evolving as the global aircraft fleet has become ever more reliant on the financing and leasing market. This week’s chart illustrates the shift, as leased aircraft accounted for less than 2% of the global fleet in 1980, but increased to almost 15% by 1990 and closer to 41% in 2018. Global consulting firm ICF has forecasted that more than 50% of the global fleet will be leased by the end of 2020. Several factors are driving global airlines’ decision to lease, rather than buy. Less cash is required as lessors, not the airlines, are responsible for down payments and bulk purchasing allows leasing companies to price leases favorably compared to the cost for a lessee to own the same aircraft. Leasing also allows for more flexibility in an airline’s fleet, which can be adjusted based on new routes, traffic and competitive pressures. Lessors bear the residual risk of an aircraft and have developed the skill sets to re-market or “part out” older aircraft. It has been said that in strong market environments, airlines look to lessors for additional capacity; while in weak markets, they look to lessors to free up cash, often through sale-leasebacks.

Several strategies are available to private investors to tap this opportunity, including financing new aircraft, leasing and re-marketing mid-life aircraft and focusing on end-of-life aircraft and part-out strategies. Each entails its own risks, including counterparty, operating, currency and sovereign as well as residual risk. The overall market will likely face pressures if consumer demand starts to soften and/or interest rates, oil prices or labor costs rise, putting pressure on airline margins and their demand for additional capacity from lessors.

Additionally, the industry is still dealing with the fallout from the grounding of Boeing’s 737 Max. The impact seems mixed, as mid-life lessors have seen an increase in demand from airlines looking to offset capacity issues caused by the groundings. Phil Seymour, CEO of London-based aerospace consulting firm IBA, said in reference to older Boeing 737-800s, "Used 800s are like a gold dust at the moment," and estimated that lease rates have increased by 40% since regulators grounded the Max. Some new-build lessors financing the purchases of the Max have been unable to write new business. A Financial Times article noted, “One of the factors shielding the industry from the Boeing fallout is that airlines will still be making lease payments in the hope of recovering compensation from the U.S. airplane maker.”

Key Takeaway

Aircraft leases offer attractive cash flows backed by hard assets that can be moved and released if needed, as well as provide a current yield, have constrained new supply and slow but consistent demand growth. Additionally, many of these leases are relatively long in duration, so investors have more visibility in terms of cash flows compared to many other shorter-term lending strategies. For private investors, finding partners with maintenance and engineering teams, a focus on high-quality collateral, as well as the ability to remarket both planes and parts can lead to an attractive opportunity to add yield in what is still a low-rate environment.

Tags: Airlines | Low interest rate | Investment strategy | Aircraft

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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