Enhanced equipment trust certificates (EETCs), a specialized form of aircraft-backed debt, have been under severe pressure due to COVID-19, paralleling the effects of the pandemic on the airlines that issue them. Here, S&P Global Ratings addresses some frequently asked questions about our ratings on EETCs, including those related to our recent request for comment on a proposed revised methodology for rating them ("Request For Comment: Methodology And Assumptions For Rating Aircraft-Backed Debt And Enhanced Equipment Trust Certificates," Nov. 18, 2020).
Frequently Asked Questions
How have our ratings on EETCs changed during the COVID-19 pandemic?
EETC ratings have almost all declined since Jan. 1, 2020. Rating changes span from no effect to a nine-notch downgrade for an EETC issued by Latam Airlines Group S.A., which filed for bankruptcy in May. The average cumulative downgrade is about 3½ notches. Chart 1 shows the distribution of rating changes among 90 issues outstanding Jan. 1 through Nov. 19.
Much of this movement was due to our lowering issuer credit ratings (ICR) on airlines, since we notch up EETC issue ratings from the ICR (Chart 2). Note it counts the number of EETCs affected, not number of airlines. Thus, our three notches of cumulative downgrades of American Airlines Inc., the largest issuer of rated EETCs (more than one-third of the total), has a disproportionate effect on this data. Overall, airline ICR changes accounted for an average of about 2½ notches among rated EETCs.
What caused us to downgrade EETCs in excess of airline downgrades?
Declines in the EETC ratings uplift above the ICR on an airline averaged about one notch. Chart 3 shows how these changes were distributed.
Most of the changes in EETC ratings uplift were zero, one, or two notches downward. However, there were cases in which the rating uplift for an EETC increased. This reflected idiosyncratic factors such as situations where the EETC rating was constrained by the rating on a liquidity provider supporting the transaction--and that constraint was less relevant as the ICR on the airline declined--or where an airline transitioned from investment-grade to speculative-grade (e.g., Delta Air Lines Inc.). We may apply more stringent overcollateralization targets for an airline with an investment-grade rating, as a higher-rated airline would tend to enter bankruptcy in more difficult industry conditions.
Our ratings on EETCs can be well above an ICR on the airline because a default on the certificates occurs only if:
- The airline enters bankruptcy;
- It either liquidates or reorganizes but rejects the secured aircraft debt or leases that collateralize the rated certificates; and
- Proceeds from repossession and sale of the aircraft collateral are insufficient to repay principal and interest due on the certificates.
The chance of these three events happening in succession is almost always less than that of an airline bankruptcy filing.
To reflect this, we assign affirmation credit based on the likelihood the airline will reorganize successfully if it enters bankruptcy and will agree to keep paying on the certificates. This could occur if the airline either affirms (agrees to perform on) the secured debt on each aircraft in the collateral pool or it negotiates revised payment terms with the controlling party (the senior class of EETCs) that preserves payment to that class but not necessarily more junior classes of EETCs. We assign collateral credit based on the likelihood that repossession and sale of the aircraft would be sufficient to repay principal and interest (which could take the form of repaying advances by the liquidity provider). Charts 4 and 5 show changes in affirmation credit and collateral credit to date in 2020.
We lowered affirmation credit principally in cases where an airline announced it was accelerating its planned retirement of either a particular aircraft model or certain older aircraft in its fleet. In those cases, we see less likelihood an airline would affirm an EETC secured partly or entirely by such aircraft.
We lowered collateral credit mainly where the loan-to-value ratio of a particular EETC deteriorated (increased). This was for various reasons. In some cases, the value of the planes in the collateral declined more quickly than the EETC amortized. In others, we decided to focus our analysis more on aircraft value measured by appraised current market value (when such values are unusually stressed) and less by appraised base value. Base value is the long-term trend of values without consideration of the balance of supply and demand for a particular aircraft model. The more we believe a repossession and sale of aircraft is likely (because the airline's risk of bankruptcy is higher, or appears less likely to affirm the EETC in bankruptcy), the more inclined we are to focus on current market values in calculating loan-to-value.
In the depressed state of the aviation industry, the gap between base value and current market value has widened, increasing risk for creditors secured by aircraft. This varies significantly from one model of plane to another. Nonetheless, loan-to-value and thus collateral credit actually improved in cases where EETC debt is amortizing more quickly than collateral value declines (Chart 5).
Why did S&P Global Ratings release the proposed new equipment trust certificate (ETC) and EETC methodology now?
We have been working on an updated approach for rating EETCs and other aircraft-related debt since last year. We developed and wrote most of the new methodology before the COVID-19 pandemic arose. We held off releasing our proposed methodology to observe how the aviation industry evolved and how reduced passenger traffic would affect airlines and aircraft values.
The primary motivation for our EETC methodology update is to provide investors with more transparency as to how we formulate EETC ratings, as well as to provide more specific guidelines for analyzing credit risk during industry stress. (This includes stress linked to macroeconomic recession, the effects of terrorism, or a pandemic such as COVID-19 on demand for air travel.) Our proposed approach also provides more detailed guidelines for how we would apply case-specific adjustments to arrive at an EETC rating.
In our current methodology, the number of notches of ratings uplift above the ICR on the airline is generally equal to the sum of affirmation credit and collateral credit. Therefore, we largely capture any risks, stresses, and positive protections through these assessments. The proposed methodology introduces a combination of matrices and ratings limitations, and therefore the final uplift above the ICR on an airline may not equal the sum of those two assessments.
How will the new methodology affect ratings?
We expect our proposed criteria, if implemented, to result in rating changes. Based on our preliminary testing, approximately 30% of ratings on ETCs and EETCs could change. The majority of these changes would be the result of the proposed modifications to our approach to assessing collateral credit and combining it with other analytical considerations, which results in more conservative collateral coverage for certain rating outcomes. Other rating changes would be due to more conservative assumptions, in some cases, regarding the likelihood the airline would reorganize and affirm an ETC or EETC (affirmation credit). Overall, we expect almost all rating changes would be limited to one notch, with significantly more downgrades than upgrades.
S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
We encourage interested market participants to submit written comments on the proposed criteria by Dec. 18, 2020. See our request for comment publication to review the proposed methodology and how to submit feedback.
- Request For Comment: Methodology And Assumptions For Rating Aircraft-Backed Debt And Enhanced Equipment Trust Certificates, Nov. 18, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Philip A Baggaley, CFA, New York + 1 (212) 438 7683;|
|Secondary Contact:||Alessio Di Francesco, CFA, Toronto + 1 (416) 507 2573;|
|Criteria Contact:||James A Parchment, New York + 1 (212) 438 4445;|
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