Sky-high yields attract DFMs to cyclical aircraft leasing

Airline travel is among the most cyclical areas of consumption with Monarch Airlines and Air Berlin among recent high-profile blow ups in the sector, but with yields upwards of 8% many discretionary fund managers are allocating to aircraft leasing.

Aircraft leasing investment trusts currently hold £3.6bn, according to the Association of Investment Companies, accounting for four of the six products in the Specialist Leasing sector.

The £2.2bn Amadeo Air Plus Four is the largest while the oldest is the Doric Nimrod Air 1, which launched in December 2010, although it only holds one aircraft and therefore does not count as diversified investment company within the AIC universe.

This month, the Sirius Aircraft Leasing fund aims to raise $250m at IPO. Former Ryanair deputy chief executive Howard Millar will lead the investment advisory team.

Aircraft leasing is currently the only exposure Architas has to the leasing sector, says Solomon Nevins, co-manager of the Diversified Real Assets fund. “We see it has a nice diversifying source of income; a way to de-risk some of the high yield or emerging market debt we might have otherwise.”

Investment trusts began moving into aircraft leasing following the global financial crisis when banks were withdrawing from the market, Nevins says. Leases are asset backed and the planes are ring-fenced so other creditors won’t get a stake on the plane if an airline were to fail, he says.

Investment Trusts Leasing sector performance

Source: FE Analytics

Cyclicality, fuel costs and US dollar

But the team behind the Sequoia Economic Infrastructure Income fund is concerned aircraft leasing is risky at this stage of the cycle. It reduced its allocation from 5.3% of net asset value 12 months ago to 3.1% today.

The cyclicality of the sector, jet fuel costs and the rising US dollar drove this reduction, says portfolio manager Steve Cook. “Airlines go bust all the time, but clearly the rate is increasing.”

He points to Alitalia and Air Berlin as examples of problems in the sector. The Italian government is currently seeking a buyer for Alitalia after it went into administration in May 2017 while Air Berlin went under in October 2017.

“You’ve got to bear in mind a lot of these airlines make a lot more money in the summer than the winter so you’ll always find there’s a few more defaults over the next couple of months,” Cook says. Emerging market airlines could be particularly vulnerable due to the sell off in their currencies, he adds.

Diversified, asset-backed yield

However, a number of DFMs are drawn into the sector.

The BMO Gam Navigator Distribution and Navigator Moderate funds hold 2% and 1.5% respectively in Amadeo Air Four Plus, while the RLAM Monthly Income Bond and Sterling Extra Yield Bond funds also both hold the investment trust in their top 10.

The Seneca Diversifed Income fund has 2.3% allocation to Doric Nimrod Air Two while Newton Multi-Asset Diversified Return holds 1.53% in Doric Nimrod Air Three, according to FE Analytics data on the funds with the largest holdings.

Nimrod Capital sales and investor relations representative Ben Heatley says the firm has seen increasing interest from DFMs year on year. The sector offers high dividends that are effectively fixed and backed by flag carriers.

“We continue to see investor interest in the sector, albeit there is some way to go until asset allocators have an ‘aviation bucket’ like they do for property,” Heatley says.

The team behind Waverton Real Assets will take a 2% position in aircraft leasing when the fund launches at the end of November, noting the initial 8% yield and double-digit total returns represent a compelling proposition relative to many fixed income opportunities.

Architas Diversified Real Assets holds 3% in Amedeo Air Four and 0.4% in Doric Nimrod Air Two, plus about 1-2% in other funds in its multi-manager range.

Using Amedeo as an example of how investment trusts in the sector are set up, Nevins says it launched with a 35% equity holding in the aircraft. Debt funding for the remaining 65% stake is paid down over the 12-year life of the fund using income from the lease, which also contributes to the 8.5% yield. “At that point, the planes are fully paid down and essentially for your 35% equity stake you have a 12-year-old Airbus A380 that you’ll sell on the secondary market.”

‘A big, illiquid emerging market bond’

However, Rathbones head of multi-asset investments David Coombs describes airlines as one of the most cyclical areas of consumption and one of the first things people give up when times get hard.

Describing one aircraft leasing fund’s pitch, Coombs says: “It owned three brand new A380s which were lent to Emirates, a state-owned enterprise.

“The value of the fund was based on the discounted value of the planes at the end of their lives. No-one knew how much they would be worth in a quarter-century’s time because no A-380 has ever been retired, so a valuer was simply reiterating that wild first guess every six months.”

That’s why its volatility was so low, says Coombs. “When you stripped it down, the fund was really a big, illiquid bond issued to an emerging market sovereign.”

Nevins says planes have historically traded at 50% of their initial price at the end of a 12-year lease, which provides a decent cushion from the 35% equity stake initially put in by investors.

The fact the A380 hasn’t been the “blockbuster success” Airbus had hoped means that cushion has been helpful, he says. Architas monitors secondary markets to ensure the going price for used aircraft doesn’t fall below their equity stake. “There’s definitely risk. You don’t go getting 8.5% yield for not taking any risk,” he says.

Narrow vs wide-body aircraft

Alternative income specialist RM Funds has historically shied away from aircraft leasing because investment trusts current focus almost exclusively on wide-body aircraft, those with a double aisle, says fund manager Pietro Nicholls.

The Sirius Aviation Capital IPO is therefore noteworthy for its focus on narrow-body aircraft with a single aisle, Nicholls says. He reckons demand for wide-body aircraft has been in decline due to the development of more efficient long-range narrow-body alternatives.

However, narrow-body planes are more commonly used by budget airlines and can be a more cyclical area of the market, says Nevins.

Regardless, Architas is not participating in the Sirius IPO due to other factors. “While the management team have obviously got experience within airlines at the highest level, they don’t have any track record of running a fund.”

If the team makes a success of the investment trust, Architas would consider participating in future rounds of fundraising, he says.