Avolon seems mostly to have insulated itself against shareholder HNA Group, which is dealing with liquidity issues after a global spending spree over the past couple of years. But the lessor's cost of capital is rising rather than falling.
When annual earnings were disclosed by Avolon on 22 February, it emerged that the company had amended the covenants of its bonds with a restricted payment clause. The bonds traded up at the time.
The mandatory redemption provision was established to assuage investors' fears that majority shareholder HNA could extract money from cash-flow-positive Avolon.
Fitch Ratings wrote in a 22 February report that the covenant "further formalises the segregation of Avolon's financial resources from Bohai Capital and HNA Group". The ratings agency added that it viewed the development "favourably".
Avolon chief financial officer Andy Cronin stated during an earnings call that the covenant had "been structured to require a mandatory redemption of the notes were we ever to make certain shareholder payments or affiliate investments in excess of defined thresholds", adding: "In this context, shareholder payments include dividends, intercompany loans and share repurchases."
Essentially, the provision prevents either Bohai Capital or majority owner HNA Capital from stripping cash via a dividend or other type of payment. One aircraft leasing executive calls it an "insulation framework".
Avolon's weighted-average interest rate, the February earnings call revealed, is 4%. That said, its unsecured notes issued earlier this month carry a 5.5% coupon. The four-year bond (issued 1 March) was trading under par at a yield of 5.78% in the afternoon of 19 March, Bloomberg data shows. This contrasts with other large aircraft lessors whose 2023 bonds are trading between 3.6% and 4%, a 120 to 180 basis point discount to Avolon.
Prior to HNA's liquidity troubles hitting headlines globally, Avolon was striving for an investment-grade rating, which confers a status described as "sacrosanct" by Air Lease's chief executive John Plueger.
Avolon chief Domhnal Slattery told FlightGlobal in October: "We are not investment grade – so I'm not quite at the cost of debt I'd like to be, but I'm tracking to that." He added: "It's an inevitability in my mind."
The lack of an investment-grade credit rating, combined with what might be termed "HNA overhang", appears to be a significant cost of capital disadvantage. Ignoring taxes, and assuming 75% leverage and a 10% cost of equity on new originations, Avolon's total cost of capital would be 6.7% compared with the mid-point of the comparables (AerCap, Air Lease, BOC Aviation and SMBC Aviation Finance) at 5.2%, or a premium of about 150 bps.
Meanwhile, Avolon's core business – aircraft leasing – remains healthy, recording a $550 million profit for 2017.
But despite Slattery's efforts to insulate his company from its parent's woes, the ratings agencies appear to remain wary. Fitch, which does not publicly rate HNA or Bohai Capital, considers both to have "highly speculative risk profiles", it says in its February report.
On 1 March, another ratings agency, S&P Global, wrote in a report that it was unlikely to increase Avolon's credit rating due to the company's current ownership structure, and warning that it could in fact lower the rating over the next year if "we no longer consider Avolon to be an insulated subsidiary of Bohai or we no longer consider Bohai to be delinked from HNA".
Avolon, of course, has access to other funding alternatives, like term loans, secured funding and asset-based securitisations (it closed its second earlier this month). But for unsecured funding – currently in vogue with lessors that can access the market – Avolon may find its premium an impediment.
Is HNA's ownership – precisely the thing Slattery once touted as his strategic advantage – now the thing that could ultimately undo Avolon's competitiveness?
Source: Cirium Dashboard
