Knocked down but not out

From crisis to crisis: Two years ago, COVID 19 forced the unprecedented closure of much of the global economy, industries such as aviation being hit especially hard as countries closed borders and banned internal travel. Smaller airlines failed whilst larger operators sought government bailouts, all the while desperately trying to exit, or at least defer, lease payments for aircraft no longer flying. Through coordinated government support, the economic impacts of such closures were mitigated but the impact of a failing aviation sector on aircraft securitisations, especially mezzanine and junior notes, was serious.

The fast track development of effective vaccines has allowed life to return to at least a semblance of normality, bringing with it a revival of internal and global air travel. Demand for planes and aviation lease rates were finally starting to recover into 2022, with brighter skies seemingly ahead. Investor interest once again focused on the optionality available in deeply discounted aviation securitisations. Prices, and liquidity improved and new transactions were placed.

Then, on February 24th 2022, Russia invaded Ukraine. Quick and coordinated sanctions from the Western world ensued, including the banning of Russian aircraft from much of the rest of the world’s airspace. Russia retaliated, ultimately leaving foreign leased planes stranded in Russia and at risk of sequestration.

Let’s frame the problem? According to the Russian transport minister Vitaly Savelyev, Russian airlines had almost 800 planes registered in the country, of which 515 were leased from international lessors. The asset value is seen in the range of $10bn to $15bn. Russia was the 11th largest market for air travel pre-COVID. Current sanctions prohibit foreign lessors from accepting lease payments on ‘planes whilst a rapidly changing Russian legal framework looks set to cancel these contracts anyway, or at least force payment in Rubles.

More relevantly, Western sanctions effectively shut Russian operated aircraft out of their maintenance cycle which will eventually impact the airworthiness of airframes, especially if “foreign” planes get cannibalised to keep the “domestic” fleet flying given the inability to source spare parts from the manufacturers in the West. In addition to the direct damage inflected in Russia, airlines and lessors are also having to cope with soaring fuel costs and another blow to consumer and business confidence.

What happened since? International lessors have cancelled their leases, attempting to repossess the planes. According to the Russian transport minister, by late March 78 planes had been recovered by lessors when they landed on foreign airports. As a result, Aeroflot and other airlines have stopped flying leased planes to even unembargoed overseas destinations (e.g. India), to protect their fleet. Recovering any further planes out of Russian seems very unlikely at this stage, potentially leaving lessors facing a total loss on their equipment.

The Opportunity? At the moment it is very difficult to find any silver lining to the current aircraft securitisation story. Admittedly, not all aviation transactions are as equally affected and many ABS hold little or no direct Russian exposure. Whilst prices for these deals have fallen alongside those with Russian exposure, the expected loss of underlying assets is remote supporting longer term recovery of value.

On a more option value approach, analysts are starting to look at the potential for sequestered assets to be covered by insurance as an act of theft rather than act of war. This last point is relevant as Russia has not “declared war”, suggesting some policy underwriters may try and sidestep claims. This path is far from certain and will definitely lead to long, complex and expensive litigation. This last point is important for aircraft securitisation noteholders as litigation costs would come out of a deal’s cashflow, ahead of even senior note interest.

There is also a “glass half full” argument which suggests Russian operators will not want to be permanently shut out of the global aviation market and, as such, will not only make good missed lease payments but also maintain aircraft, or at least not strip down airframes for spare parts. Combined with views on insurance cover, this argument can drive interest in the bonds with perceived option value: those notes in the debt stack trading for a few cents on the dollar as the base case scenarios all suggest zero (or minimal) longer term recovery. For those investors with an appetite for high risk and opportunities with limited visibility on cash flows, the sector may offer interesting upside as global aviation resumes its recovery cycle in the years ahead.

by Michael Husemann, Sr. Analyst