The historical performance, and recovery, of EETCs show the strategic importance of aircraft for airlines, even in bankruptcies. The strategic importance of the asset to the airline’s operating strategy and the leverage that bankruptcy law provides creditors are the driving factors that induce airline managements to set a high priority on payment of EETC certificates ahead of other obligations, says the credit rating agency.

Turkish Airlines' debut EETC, a $328 million issuance in March 2015 is part of a broader trend of non-US airlines using EETCs to fund new aircraft deliveries. Turkish is financing three Boeing 777 through the issuance.

Traditional credit analysis of the cash flow-generating ability of an airline would have predicted neither the behavior of airline managements nor the performance of EETCs over the past decade it says. In the U.S., the default rate among airlines has been extremely high, with almost every major EETC issuer filing for bankruptcy between 2001 and 2011 (including U.S. Airways, United Airlines, Northwest Airlines, Delta Airlines, and American Airlines). Yet, “A” tranche EETC loss rates (including principal and interest) were extremely low (less than one half of one percent), regardless of the issuer or its cash flow-generating ability. 'The primary contributor to this outcome has been the importance of the assets to the airlines’ operating strategy during and after bankruptcy, which resulted in affirmation of aircraft collateral in most cases.'

KBRA analysed 107 EETC tranches from eight issuers that filed for bankruptcy (two of which filed twice) from 2001 to 2005 with an original face value of $22 billion, and found that the ultimate “A” tranche recovery was 99.8%, with 98.5% of all “A” tranches unimpaired. The vast majority of the aircraft in KBRA’s study remained with the airline originating the EETC. The reason for this is that all of the major airline bankruptcies in the U.S. are reorganizations rather than liquidations. 'Most reorganized airlines emerge from bankruptcy financially stronger and want to retain a good portion of the fleet as part of an ongoing operating strategy; thus, airlines have been more likely to affirm than reject the aircraft in EETCs. KBRA says this works to the benefit of secured aircraft lenders. KBRA also found ultimate recoveries for all “B” tranches of 96.1% (with 93.3% of all “B” tranches unimpaired) and ultimate recoveries for all “C” tranches of 92.7% (with 64.9% unimpaired). The loss severity of those “B” and “C” tranches that were impaired was more disparate, ranging from 13-86% and 13-97%, respectively, compared to “A” tranche recoveries that ranged from 70-93%.'

With such a strong track record during a period of restructuring and upheaval in the US airline industry the attractions of EETCs to investors, at least in American experience, are clear with a number of successful issuances outside of the US taking place this year so far. For instance LATAM issued the first ever EETC in Latin America in May 2015 while other recent non-US issuers include Emirates, Turkish Airlines, Air Canada and British Airways. The EETC was initially a US product but as other jurisdictions introduce bankruptcy rules equivalent to Section 1110 of the U.S. bankruptcy code (it provides an aircraft lender with certainty around the timeframe under which it may repossess and remarket its collateral i.e. the aircraft) the issuance of non-US EETCs has become a possibility.

Looking at the wider secured aircraft debt market, KBRA says that secured debt/loan structures tended to be simpler, with a reliance on the creditworthiness of the airline as the foundation on which a credit rating was built. However, there has been a recent trend where hybrid structures are being created that use EETC-like features such as liquidity facilities (often in the form of PIKs), other structural features (e.g. balloon payments) or subordinated tranches which create additional safeguards for investors' return beyond a plain vanilla secured loan.

Aircraft as collateral
KBRA also sets out the positive attributes and risk factors for aircraft as collateral in transactions.

The unique features of aircraft as collateral are important building blocks to KBRA’s rating view of EETCs and secured loans. There are a number of positive attributes of aircraft collateral, as well as a number of risk factors specific to this kind of collateral, that KBRA considers in order to gauge the level of protection the collateral affords.

KBRA's positive attributes of aircraft collateral include:
Liquidity - Generally, KBRA views the market for commercial aircraft as reasonably liquid, while acknowledging that each aircraft type has different liquidity at any given time. There are currently more than 19,000 aircraft in-service globally, valued at approximately $445 billion, with over $100 billion of new aircraft expected to be delivered each year for the next several years. Given the large and growing installed base of aircraft, the secondary market is both deep and global with hundreds of participants potentially seeking all types and models. While some purchasers, such as large global airlines and some aircraft lessors, are willing to pay high prices for newer aircraft, other investors, such as smaller regional airlines, asset managers and operators in developing markets are looking to invest at a lower capital cost commensurate with a lower revenue-per-seat business model. Further, both developing and emerging markets have needs for small, mid-size, and large aircraft.

The growth of the aircraft lessors has also contributed to secondary market activity because leasing companies are active sellers of mid-life and end-of-life aircraft. Although KBRA notes that more leasing companies have espoused disposition rather than acquisition of mid-life assets, given the potential yield opportunities a number of new financial players, such as investment funds, have emerged and are acquiring mid-life assets. Similarly, the depth and variety of financing available to potential buyers of aircraft further supports activity and liquidity in the secondary markets.

Section 1110 Bankruptcy Treatment - Section 1110 provides an aircraft lender with certainty around the timeframe under which it may repossess and remarket its collateral. Pursuant to Section 1110 of U.S. bankruptcy law, any aircraft with six seats or more, operating on a commercial basis, qualifies for Section 1110 treatment should the debtor or lessee default.

The benefit of Section 1110 to aircraft owners is that the aircraft will not be subject to the automatic stay by the bankruptcy court. Other secured lenders, whose collateral is not eligible for 1110 treatment, cannot repossess their collateral until management has presented a plan for reorganization that is approved by all parties and the court, which can take two or more years to complete. KBRA views the legal framework for repossessing aircraft in case of an obligor bankruptcy as an important driver for valuing collateral in secured aircraft transactions and ultimate recovery for investors, and thus a key consideration for our ratings of these securities.

Strategic value - In many cases, specific aircraft are strategically important operating assets to an airline or the equity owner, because without use of the asset, the company’s revenue and profits would be negatively impacted. Larger airlines generally follow a fleet policy based on scheduled service that is core to their competitive marketing strategy. To meet this commitment while maximizing efficiency, most airlines operate their aircraft with high utilization and minimum downtime. To maintain its service commitment, an airline often views access to aircraft as a high priority, to the benefit of secured-debt holders.

Mobility of aircraft - Aircraft are easily repositioned from operator to operator, and there are numerous agents capable of repossessing and remarketing aircraft, greatly increasing the potential buyer base and thus liquidity.

Parts are worth more than the whole - Regulatory restrictions prohibit a part to be installed on commercial aircraft unless it has been certified by the FAA, thereby creating inelastic demand for parts and thus a high-margin trade in spare parts. Indeed, the value of the spare parts comprising an aircraft is often worth more than the whole, which further supports the overall value of aircraft collateral in general. This has provided an arbitrage opportunity for both owners and financiers of end-of-life aircraft and more recently some mid-life aircraft- another boost to liquidity.

KBRA's risk factors related to aircraft collateral include:
Depreciation - Aircraft are long-lived assets that decline in value, particularly those that have high utilization. Similar to automobiles, the value curve over the useful life of the aircraft, which is approximately 25 years for most types, is not a straight line. For aircraft, yearly value degradation tends to increase over the life of the aircraft. To protect investor capital, it is imperative that debt levels (loan to values) are maintained below the value curve with ample cushion to cover remarketing and maintenance costs (including engine overhauls and heavy airframe checks, if necessary) and the expected value decline during a market downturn. This is particularly true during periods of more rapid technological change, which tend to accelerate value degradation and thus increase aircraft depreciation rates.

Heterogeneous product - Just as with other transportation assets, some aircraft models are big sellers with many buyers whereas others sell in low volumes with only a few buyers. This dynamic can greatly affect the liquidity of an investor’s collateral pool. For example, the Boeing 737-800 and the Airbus A320-200 are the most widely held aircraft in the world and can be readily sold in the secondary market. In contrast, 50-seat regional jets have a small and declining operator base and therefore are relatively illiquid.

Cyclicality - Similar to many other markets, aircraft liquidity is cyclical and is also subject to non-cyclical shocks. In periods of idiosyncratic stress, such as following the events of 9/11 or during the depths of the financial crises in 2007-2008, the secondary market for aircraft was illiquid, albeit for a short period of time. During cyclical downturns associated with the airline industry, these periods have spanned several years, though history has shown that market dynamics eventually recover, commensurate with the underlying fundamentals in the airline industry. KBRA typically looks at historical data specific to aircraft types to estimate cyclical volatility. If data is unavailable for some models, KBRA utilizes proxy data estimates. In addition, KBRA’s valuation and stress scenarios incorporate changing views on the behavior of aircraft markets.

Maintenance requirements - As aircraft age, maintenance requirements and costs increase, raising the amount of collateral cushion needed to protect a lender against principal loss or below-expected returns.

Return conditions - Airlines that find themselves in financial stress often manage their operations so that upon filing bankruptcy, they have used up most of the engine time allowed before a major overhaul is required under FAA guidelines. This diminishes collateral protection for investors and requires large cash outlays before remarketing can begin. While it is possible to sell an aircraft with little remaining engine time, it can greatly weaken the seller’s negotiating position. This is less of an issue with well-diversified ABS transactions, which can absorb the cost more easily given the size of the pool, compared to EETCs or secured loans that are more reliant on a single or small pool of aircraft operated by a single airline.