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Aviation: Etihad partner defaults show aviation cracks

Air Berlin and Alitalia bankrupt after CEO change at Etihad; Abu Dhabi backs partner bonds.

James Hogan

Lower oil prices have fuelled a boom in aviation finance, as banks and investors search for asset-backed business to replace the downturn in shipping.  After the bankruptcies of two European affiliates of Etihad Airways this year, Alitalia in May and Air Berlin in August, investors thought their problems were largely isolated from the rest of the sector. But the defaults also show how the lower price of the sector’s biggest expense is having a surprisingly negative, if delayed, effect in the Gulf – and have raised questions about which other parts of the industry could face trouble.

At Air Berlin, rather than empty planes, the problem was a muddled long- and short-haul strategy and a cost base out of sync with revenues, says Henrik Haeder, head of Europe at investment management and advisory firm Transport Capital. 

However, the trigger for bankruptcy (as at Alitalia) came when its main financial backer baulked at providing further support, following the departure of Etihad Airways’ long-standing former chief executive James Hogan, earlier this year.

Growth strategies

Airlines from states such as the UAE – where Etihad and Emirates are flag carriers of Abu Dhabi and Dubai, respectively – have grown rapidly to complement national development strategies. 

Yet bankers say the 2014 oil crash has dampened the Gulf’s appetite for international investment. 

Meanwhile, partly thanks to Donald Trump’s travel ban on some Muslim-majority countries, the Middle East was the only region where growth in passenger numbers slowed in the first half of 2017, according to the International Air Transport Association (IATA). 

Qatar Airways is also rerouting flights due to a regional trade embargo and backed out of a bid to buy 10% of American Airlines this summer in the face of US coolness.

Hogan’s strategy involved taking large minority stakes, acting as something of a white knight for struggling airlines, while plugging new routes into Etihad’s network, says Roger King, transport analyst at CreditSights. 

Etihad posted a $1.8 billion loss for 2016 after losing money on fuel-hedging contracts and writing off lower market values for aircraft and exposures to Air Berlin and Alitalia. 

Bonds backed by $1.2 billion in senior unsecured loans to affiliates of Etihad, issued via EA Partners and due in 2020 and 2021, traded down to about 85 cents on the dollar after Air Berlin’s announcement. 

Fitch downgraded the notes to CCC-. With 40% of the underlying debt in default, the EA Partners bonds’ reserve fund could be depleted within a couple of years, says King. 

Although there are no cross-default obligations, analysts at JPMorgan and elsewhere say AA-rated Abu Dhabi is concerned for EA Partners’ local bondholders and the perceived creditworthiness of its other government-related entities.  It is reportedly covering part of the special purpose vehicle’s loans to Alitalia and is rumoured to be planning the same for Air Berlin.

Struggling carriers

Other flag carriers owned by states more financially constrained than Abu Dhabi are already struggling to turn a profit.  Fitch and Standard & Poor’s downgraded the South African sovereign to junk this year, for example. State-owned South African Airways has a stringent cost-cutting programme to stem its losses. 

Burden of friendship
Etihad Partner bonds’ participation
Airline Etihad EA Partner I  EA Partner II
stake $mln $mln
Etihad Airways 100% 132 89
EAS 100% 113 99
Air Berlin 29% 132 100
Air Seychelles 40% 21 50
Alitalia 49% 132 100
Air Serbia 49% 56 63
Jet Airways 24% 113 n/a
Source: CreditSights

“Other airlines reliant on questionable shareholder backing may now have to accept higher financing costs and rely more on asset-backed borrowing,” says Bert van Leeuwen, head of aviation research at German transport lender DVB. 

Van Leeuwen also points to rapidly growing independent airlines and leasing companies entering at the market’s peak.  Lessors own the majority of Air Berlin’s 146 planes, primarily GECap, Avolon and AerCap, according to CreditSights. 

With other airlines (notably Lufthansa’s low-cost arm Eurowings) reportedly interested in taking over the planes and routes, King says the lessors will fairly easily distribute remaining aircraft as there is so little spare capacity in the industry.

Long-term dangers

The longer-term danger for the industry as a whole could be that airlines are less frugal with costs and ticket prices while fuel is cheaper – causing problems when oil rebounds. 

Firms with low profitability now could post heavy losses later.  If a big default undermined confidence in the industry, financing costs would rise, perhaps eventually leading to bigger equipment surpluses, hurting collateral values. 

After initial effects in shipping, China’s economic liberalization is now resulting in ever-growing numbers of airline passengers, according to van Leeuwen.  In the first half of 2017, fare-paying plane passenger kilometres rose at their fastest rate since 2005, according to IATA. 

Asian banks are jostling for airline and aircraft leasing customers alongside lenders elsewhere, especially Germany.  For capital market investors too, aviation finance seems to offer a safe if low return, usually underpinned by a tangible asset. “We still see a lot of liquidity in the aviation market,” says Haeder. “Loan-to-value ratios are going up and prices are going down.”