DBRS Morningstar’s Takeaways from SFVegas 2023: Interest Rates Keep Aircraft ABS Grounded

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at SFVegas, an industry conference for the structured finance/asset-backed securities (ABS) sector. DBRS Morningstar’s Hylton Heard, Senior Vice President, likened the outlook for aviation ABS to his view outside his hotel room in Las Vegas. “All sunny and blue skies,” he said, “and then over the mountains—clouds.” Aircraft values have improved significantly as supply has not yet met the comeback in air travel demand for most of the world, with the exception of China. “I’m sure all of you flying out here were on full planes, no doubt,” Heard added. In terms of ABS performance, cash flows have stabilized across the board with some improvement in deals. Heard noted his biggest takeaway from the Aviation Economics conference in Dublin was the stronger credit of lessors’ airline customers globally, including increased revenue and many now being profitable today.

The outlook looks bright for sure, but the clouds over the mountains are the effects of the macroeconomic environment, including inflation. This can be a real game changer for travel demand, especially if layoffs start to increase and airfares stay at elevated levels or rise even higher. In addition, Heard noted rising airline costs across financing and labor, industry operational issues, and intense competition will continue to challenge airline credit metrics in 2023. Further, the continued Russia-Ukraine war means that geopolitical risk remains present in 2023. Ultimately, aviation continues to be one of the most volatile sectors across ABS.

Then again, the aviation industry is used to turbulence. In 2022, there were only three new aircraft ABS transactions, a significant drop from 15 the year prior. Kinnary Armstrong, Executive Director at Mizuho Americas, explained one big reason for the lower number. Simply put, aircraft lease rates and benchmark interest rates are out of sync. Lessors, issuers, and investors benefited from the prolonged low interest rate environment that granted enough excess spread to make securitization profitable. Now the industry is navigating significantly higher interest rates, but the underlying lease rates have not changed. Armstrong reminded the audience that underlying lease rates for new narrow-body aircraft last seven to 10 years. Leases signed during the low interest rate period still have multiple years left before they end; therefore, the amount of potential collateral for new aircraft ABS is limited.

However, Armstrong believes lease rates will rise over time because the pickup in travel has generated demand for aircraft assets. She has heard from her company’s clients that some lease rates are 15% to 20% higher for narrow-body aircraft. Eventually, she believes benchmark interest rates and lease rates will reach an equilibrium so that securitization becomes profitable again.

Chris Gray, Senior Vice President at Oaktree Capital Management, agreed but found it strange that the lease rates are rising because of supply and demand alone. “There’s really been no effort to pass higher base rates to lease rates,” he said.

Will issuers eventually return to securitization in 2023 or continue seeking alternative financing options? Michael Liu, Managing Director at Guggenheim Securities, believes they will return to the ABS market. He has seen strong demand for senior notes in pre-pandemic and post-pandemic deals, which will support new issuance. However, subordinate notes have not garnered similar attention. Liu expects new deals to have only one senior tranche and for them to continue appearing on the private market instead of the public market.

Written by Caitlin Veno

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