It seems a distant memory now, but only a few years ago the market hits its peak and promptly turned on its head, pushing all signals into the red and liquidity virtually vanished overnight. In true elastic fashion, and given the collateral damage, the market was quick to respond. With the benefit of zero/low interest rates it was able to restore productivity, re-commit the banks, consolidate an airline and lessor or two, technologically evolve, expose a chink in the armour of OPEC, and witness the industry become profitable across the board.

Stuart Hatcher

Sounds like a dream, and maybe it is, but it is a scenario that we must now evolve from as rates are on the rise. Nor should it come as a surprise, really, as we are still only at the tail end of a very troubling period in history. The economy is improving after all, but the market still remains poised for a sudden halt to the rates rise if inflation starts to gather pace. US tax breaks will play their part in the coming years as investment is made to boost productivity, but that will undoubtedly trigger rises in inflation that the Fed is desperate to avoid.

For aircraft leasing, the low rates and high cash yields have attracted many new investors into the space, with many anxious to get onto the lessor leaderboard. Acquiring aircraft organically through sale leaseback has almost become untenable as lease rate factors nudge towards 0.5% for an operator that has possibly a less than perfect credit score. So it is hardly surprising that the direct lessor order backlogs have doubled over the past five to six years. The low rates have made competition so fierce that as lease rates tumble, pricing can rise dramatically if the right lease offering comes to market. For experienced others unable to order direct, strong reserve rates, a strong residual position and the ability to refinance appropriately has certainly helped. For the rest of the market, older assets have been the avenue to greater yields - but even here you are fighting a battle to get the right return as pricing continues to rise.

Since the rates started creeping up at the start of 2016 we have witnessed much of the same as lessors continue to order direct and airlines buy and sell back into a very willing market that continues to clamber for product. Even the freight market has recovered to such an extent that feedstock has almost entirely dried up, pushing conversion ages ever closer to 25 years.

Whilst larger lessors have been pushed towards more direct sales, they continue to do very well in the secondary market as all strive to cycle their portfolios to willing investors looking for a piece of the pie - especially given that pricing still remains so high.

Interestingly, since oil pricing collapsed and technical issues have plagued the new engine technology, worries about which particular assets to invest in have been pushed aside too. Operator credit remains key, although we struggle to find operators that can fall below the low bar level set by new entrants.

Naturally, rising interest rates will potentially drive some new investors out of the space because something shinier grabs their attention. But rising rates will also expose many of the gambles taken. Pricing and yields have been moving apart for some time and once capital costs rise some investors will become very exposed. With fewer bidders and rising costs, we expect to see pricing in decline and lease rates creep up; which is good news for those who know what they are doing - and troubled times for those who have taken too much residual or operator risk.

What will the best course of action be for the airlines in a rising interest environment? When they have cash, they either order more or buy out leases, but as rates rise they will have to be more careful about how they deploy their capital. In a rising rate environment, capital costs will rise and borrowing capacity for some will become a real problem. When measured on a risk adjusted basis, ownership by the airlines will not be an economical option.

This does also point to a position where credit profiles will be affected - especially for those non-US carriers still left with high dollar denominated costs. However, the market will naturally find new ways to support a proportion of new deliveries providing operator demand remains intact. Insurance-backed security is certainly gathering pace to help those typically accustomed to export credit assistance.

So essentially, if rates rise to the point where investors start to go elsewhere (or lessor consolidation continues), airlines may have to accept a situation where the more experienced lessors take the upper hand in negotiation and return lease yields and return conditions to a stronger pro-lessor position. Assuming that increased productivity also pushes up oil, the push towards new technology will be difficult to hold back too.

This article appeared in the May 3rd 2018 edition of Aviation Finance