Joe O’Mara, Head of Aviation Finance at KPMG Ireland, provides his overview of the key issues driving the aviation market over the past year and shares insights he has learned from his discussions with major aviation leaders.
We are delighted to present you with our Aviation Leaders Report 2023: New Horizons. The report captures the views of industry leaders across the leasing, airline and banking markets and includes input from rating agencies and analysts covering the sector.
Our report last year focused on the resilience of the overall sector, as it started to emerge from the shadow of the pandemic and the recovery took hold, at varying paces, across the globe.
COVID-19 has not gone away, and new significant challenges have emerged, but the recovery continues apace and it’s clear that, while we remain in a very fractured environment, opportunities still abound.
Airlines: Riding the Recovery
From a financial perspective, global airline losses are on track to be $6.9bn for 2022. This represents a significant positive movement from the nadir of 2020 ($140bn loss) and the $42bn that was lost in 2021. What is even more heartening is that the industry is expected to return to profit this year, which would be a remarkable turnaround given the challenges that the sector has faced.
However, while the recovery is significant and meaningful, it continues to be fragmented. The geographically disparate nature of the recovery is intrinsically linked to the pace at which travel restrictions were eased.
The recovery in 2021 was driven primarily by large domestic markets. Over the course of 2022, post the Omicron wave at the start of the year, we saw strong recoveries in international traffic across the intra-Europe, Americas and Transatlantic markets. These routes are predominately back, or very close to, 2019 levels and the expectation is that growth should continue.
While Asia-Pacific has been a laggard in 2022, it has developed more positively as the year progressed and as restrictions gradually eased, we have seen international traffic move close to 80% of prepandemic levels.
In a similar fashion, the positive developments on China reopening its borders since the start of this year give cause for optimism for the recovery to grow in that region too. As China does reopen, the wider world would do well to remember the comments of the World Health Organisation (WHO) with respect to the fact that travel bans are not effective in controlling the spread of the virus.
Airlines, like many other sectors, face significant macro challenges including inflationary pressures, the heightened interest rate environment, the rising price of oil and the strength of the US dollar. Significant infrastructural challenges have also emerged over the course of the year as capacity sought to ramp back up. To date, the sector has broadly managed to buffer itself against these challenges as the bounce back in demand has been so strong.
2022 was again another year of relatively low airline failures and it also had only a small number of formal financial restructurings. Some expect that we will see more failures over the coming 12 months, but it was ever thus. In a similar fashion, we have also seen the emergence of a number of new airlines in the past year, seeking to take advantage of clean balance sheets and ride the crest of the demand cycle.
Overall, the general view of participants is that while we may see some slowdown across parts of the world, pent-up demand and heightened determination and desire to travel, should mean that 2023 continues to see a strong global recovery, with Asia in particular driving significant growth and opportunity.
Having enjoyed a low interest rate environment for an unusually long period of time, it was no great surprise to see rates rise over the course of 2022. However, driven by the inflationary environment, the swift pace of the increases, and the expectation that more is to come, have caused issues for the sector. While rates are higher now than at any time since the global financial crash of 2008, they are not out of kilter with longer term historical norms.
The aviation finance market is adapting, but it will take time. The natural upward movement of lease rate factors is taking place, but as has been the case in the past, there is a lag in the corelation with the rising rate environment.
Determining relative value with respect to debt terms, for both lender and borrower has been challenging. This uncertainty has been an impediment to some transactions progressing.
Investment grade lessors wisely filled their boots at very attractive rates in the unsecured bond markets over the course of 2021 and this, coupled with the current market, has meant very little issuances took place last year. This will likely change over the course of 2023 as the leasing community goes back to that very important and deep well. The expectation is that, despite the challenges the sector has faced in recent times, its evident resilience and the continuing maturing of the sector should result in large well-run lessors achieving similar spreads to those obtained in the recent past.
On the other side of the capital markets, the aviation ABS market had a very muted year, having bounced back stronger and quicker than most had expected in 2021. A notoriously sentiment driven space, the challenges arising from the Russian invasion, coupled with the broader challenges of the wider ABS market, meant only a handful of deals executed last year. There were some green shoots towards the end of the year, but it remains to be seen if this important financing channel will return in a meaningful way in 2023.
Stepping into the breach to fill some of this gap has been the alternative lenders. Predominately private equity backed players have played an increasing role in financing aviation transactions and the expectation is that the importance of this funding source will continue to grow.
For the wider leasing community, the rate volatility has brought home the importance of hedging and liability management strategies. Those that have a capital structure based on a stacked maturity over a longer-term period will be better placed to manage the challenges of this environment. The volatile market has also highlighted the importance of being able to access multiple funding sources and the importance of growing and maintaining relationships across the financing field.
The Age of Leasing
Since its inception almost fifty years ago, the trend line for operating lease market share has only gone in one direction. Over the course of the pandemic, the support that lessors provided and the pivotal role they played in the survival of many airlines has deepened and strengthened relationships between lessors and airlines.
With a greater appreciation for the flexibility that leasing offers and with most airline balance sheets still suffering, lessors have taken on a greater importance in funding new deliveries.
The percentage of leased aircraft has broken past that 50% threshold, and it is likely that lessors are funding closer to 60% of new deliveries currently, either via their own order books or the sale and leaseback channel. The dominant view from industry leaders is that over the medium term, the overall percentage is more likely to move towards the 60% mark than to recede.
The resilience of the leasing model has been remarkable and was evidenced further by the ability of the sector to absorb the $7bn of publicised impairments that resulted from the Russian invasion and the subsequent loss of over 500 aircraft. The court battle with the insurers will likely run for years. While the episode has caused significant challenges, both in terms of the general insurance market and the overall perception of geopolitical risk, it was impressive in how the larger players with the greatest exposure were able to shoulder the significant financial impact.
The importance of scale has been a recurring theme in our discussions with industry leaders and there is a consensus that the importance of scale from a leasing context is likely increasing. As the leasing product becomes more commoditised, as lessors seek to chase the most attractive metal, scale will continue to be a differentiator. Those that can access the widest pool of debt and equity investors, that can control maintenance costs, that can maximise their purchasing power, are the ones that will be able underwrite larger transactions and grow faster.
This scale point has driven some material M&A over the course of 2022 and there is a belief that more consolidation is likely to take place in the near term. There will be room for other players in the market, but they will need to play smarter and potentially in more niche areas.
We have also continued to see new entrants into the leasing sector, though what has been interesting is that the more notable new entrants are those that come with a vastly experienced management team but also with a sizeable war chest behind them, either in the form of significant private equity backing or with the support of sovereign wealth.
Fleet & Freight Focus
Supply chain issues and related production delays continue to hinder the duopoly of aircraft manufacturers, Airbus and Boeing. Delays on the engine side have been particularly challenging as bedding in new technology has given rise to some entry-into-service issues.
That said, both their order books reflect the high level of demand for product (particularly with respect to narrow body, fuel efficient best sellers like the 737 MAX and the A320 neo families) and those seeking to access new orders will be waiting many years.
Even with increased production on both sides, we are seeing shortages in meeting demand, and this should, coupled with the overall inflationary environment, result in an uptick is asset values. Though worth noting that the counter to this is that some lease encumbered assets may suffer from lease rate factors that reflected the previously benign interest rate environment. For those with order books, the negotiation of escalation clauses and related caps will also be of significant importance.
The wider trading environment has suffered from the OEM challenges, as larger lessors delayed divesting plans as they are forced to wait on deliveries, and the hope is that this market can return to a greater level of efficiency over the course of 2023.
On the freighter side, the surge in demand during the pandemic has cooled somewhat, on foot of global economic challenges and the return of more widebody belly capacity into the market. However, it remains an attractive space, as reflected in both the orderbooks of the OEMs and in the challenges in obtaining P2F slots for conversion. There are mixed views as to whether there is a potential for oversupply to occur in the near term, but the broad consensus is that the step change in demand on the cargo side post-COVID will be materially sustained.
Eye on ESG
The carbon reduction challenge continues to loom large over the sector and all stakeholders acknowledge and appreciate the need for immediate action. ‘Flight shame’, the imposition of environmental related taxes and regulations, and the increased Environment, Social and Governance (ESG) focus of investors, are real concerns for the industry.
While aviation contributes around 2.5% of global CO2 emissions, it’s path to reducing its carbon footprint is less clear than that of some other sectors. Offsetting is one option for managing current carbon output, but it is an area that requires more oversight and regulation, and it is viewed more as a temporary rather than long-term solution.
The primary near-term bet is in relation to Sustainable Aviation Fuel (SAF), however there are significant challenges in terms of supply and cost. We have seen interesting partnerships being explored by some lessors in relation to SAF and a concerted and more joined up effort, across the entire sector, as well as from governments around the globe, is needed if SAF is to deliver anything close to what IATA hopes it will manage in the journey of carbon reduction.
The wider leasing community has also sought to play a great role in the ESG challenge, with Aircraft Leasing Ireland, the industry group that represents the aircraft leasing sector in Ireland, developing their Sustainability Charter over the course of 2022. There is an acknowledgment from the sector that it has an important role in reducing carbon output. There are no quick and easy fixes, but we are seeing lessors set ambitious sustainability objectives and they are looking to increase collaboration across the industry to help drive meaningful solutions.
Overall, the industry outlook remains positive. The sector has weathered a shock like no other and has lived to tell the tale. The recovery and the resilience have been remarkable. There are still macro headwinds on the horizon, but with the knowledge that the demand to travel and explore remains embedded within us, we sit on the verge of the next aviation cycle with a confidence that the sector can continue to thrive and grow. I would like to thank all those who gave their time and insights, and I hope you enjoy the read.
Get in touch
If you have any queries on the topics raised in the Aviation Leaders Report 2023, please contact Joe O'Mara, Head of Aviation Finance. We'd be delighted to hear from you.
Head of Aviation Finance
KPMG in Ireland