Many different definitions exist for what constitutes an ‘esoteric’ or ‘off-the-run’ asset-backed transaction. Broadly, various research includes such disparate assets as equipment leases, drug royalty streams, catastrophe risk bonds, insurance premiums, tax liens and timeshare receivables.
Of particular note, however, are two operating type assets, shipping container leases and aircraft operating leases. Both have seen a relative resurgence of issuance over the last 18 months and share a number of key similarities: highly cyclical industries, utilization and lease rate dynamics, and weak(er) lessee profiles/concentrations.
Resurgence in ABS Issuance as Other Funding Constrained
Shipping container deals have seen the most notable growth over the last 18 months, with new container transactions on pace to potentially surpass the high-water mark witnessed in 2012. The environment has been well-suited for new container ABS issuance as economic growth has trudged on and other industry funding sources have been constrained. Through September, eight transactions totaling $2.3 billion were issued, compared with nine transactions totaling $2.6 billion for all of 2012. Considering the amount of issuance in recent years, it is unlikely that there will be material increases in 2014.
The financing landscape for commercial aircraft similarly has undergone changes in recent years, with European banks reduced lending activity and less attractive export credit financing terms. This, combined with the substantial outstanding book of orders for aircraft, has opened the door for more capital markets aircraft financing in the coming years. The market has seen notable growth, but primarily in the enhanced equipment trust certificate (EETC) market. While only a few operating lease ABS offerings closed over the past year, Fitch does expect to see a relative resurgence in aircraft ABS issuance in 2014.
The performance of operating lease securitizations for both containers and aircraft depends on utilization rates, lease rates, and asset values. All these variables are also affected by the economic environment and, therefore, demonstrate substantial cyclicality. Fitch Ratings views these variables as interdependent as they each represent the supply and demand balance (or lack thereof) in the current market.
Risks of Container Overproduction
Fitch has observed substantial cyclicality in the industry as containerized traffic is dependent on world GDP growth and trade flows. Container demand ebbs and flows with these variables. Over the last several years, however, container lessors and ABS have enjoyed high utilization rates and strong asset (leasing) volume even as lease yields have softened slightly. A weakened shipping industry has helped container lessors as “slow steaming” and a lack of funding support the leasing business. Nevertheless, it remains to be seen if lessors can control the urge for container overproduction and the risks to asset utilization.
Further compounding concerns related to overproduction are emerging demand side pressures. First, the rate of “containerization” of products is slowing. Meanwhile, decreasing offshoring of manufacturing for large economies (notably the U.S.), could reduce demand from high traffic routes such as those between the U.S. and Asia. At the same time, more shipping companies are opting for acquiring their own containers, in lieu of leasing. Finally, though the ultimate impact on container demand remains unknown, shipping alliances like the P3 could, theoretically, reduce demand for leased containers.
Obsolescence a Concern for Aircraft
The commercial aviation industry has exhibited significant cyclicality tied to the health of the overall economy. This cyclicality can produce increased lessee defaults, lower demand for off-lease aircraft, and deterioration in lease rates and asset values. During economic downturns, airline capacity tends to be reduced, leading to an increase in aircraft available for sale or lease. At the same time, the general demand for aircraft decreases, pushing down aircraft values. During these capacity reductions, values and lease rates tend to be most impacted for older, less efficient aircraft types. As a result, cyclicality concerns in these transactions are exacerbated by the risk of technological obsolescence.
More Variability in Aircraft Utilization Rates
Utilization rate is a frequently used measure of deployment of operating assets in a portfolio. For both containers and aircraft, utilization rates represent the percentage of an asset portfolio that is on lease at a given point in time. While trends for both assets generally reflect the condition of the broader market, we see substantially more utilization variance for aircraft depending on asset quality, reflecting their less homogenous nature.
Cyclicality is highly evident in industry utilization rates on dry containers (which make up approximately 90% of twenty-foot equivalent unit or TEU), tracking world GDP growth over time. Master lease agreement (MLA) leases have been especially tied to economic growth, as lessees have the flexibility to terminate leases with little notice.
Fitch views utilization rates on MLA as a key risk to container ABS transactions. These rates have historically been as low as 55% on an industry wide basis. However, Fitch notes that a floor exists on this rate, as some level of trade will always be needed. Fitch also notes that some container types refrigerated, tanks, etc. may tend to have higher utilizations due to specialized use. Finally, Fitch has observed that, during the past 10 years, MLA has declined to a significantly smaller percentage of lessor fleets. However, this trend may reverse itself and is currently not part of any container ABS concentration covenants.
Fitch has observed a clear distinction between utilization rates for what Fitch views as liquid (tier 1) and less liquid (tier 2 and 3) aircraft historically. Tier 1 aircraft tend to be those with large and diverse operator bases, such as the A320 and 737-NG aircraft. The disparity between tier 1 and tier 2 and 3 utilization declines mimic that observed for market values and lease rates during similar intervals. Both container and aircraft securitizations are exposed to lessees that are generally of poor credit quality. This stems from the characteristics of the industries in which the lessees operate (container shipping and commercial air travel).
These industries are highly cyclical, showing substantial correlation to global GDP. Broader macroeconomic recessions tend to decrease demand for these products. In the case of air travel, air travel demand declines notably during recessions. Shipped goods in general decrease in step with global GDP. In fact, the volume of containerized traffic has a significant correlation historically with global GDP. Both industries are further stressed by high capital expenditures and operating costs and as a result, volatile profitability.
Due to the above factors, lessees in container and aircraft securitizations tend to be speculative-rated or unrated and at relatively high risk of default. Further, concentrations in these lessees tend to be rather high in the issued transactions, particularly in container ABS. As a result, Fitch analyses assume default levels for these transactions consistent with marginal credits which also reflect large concentrations and heavy industry correlation.
John Bella heads Fitch’s U.S. Auto and Commercial ABS group; Brad Sohl is a Senior Director in Fitch’s U.S. ABS group.