Fitch: Novation, Tail Concentration Risks in Pre-Pandemic Aircraft ABS

Fitch Ratings-New York-25 January 2021: Aircraft operating lease ABS transactions issued prior to 2021 have two structural elements that expose senior investment-grade class A notes to elevated concentration risks, Fitch Ratings says. These risks arise when a material number of aircraft fail to novate into pools during a delivery period after closing, or if there is tail risk due to low asset count and limited pool diversification. In these situations, deal priority-of-payment (POP) waterfalls continue paying note principal pro-rata across senior/subordinate notes, not sequentially, limiting class A notes from benefitting from quicker amortization and building credit enhancement particularly later in the transaction life that could mitigate these risks.

In 2020, two aircraft ABS deals, START III and Lunar 2020-1, saw a material number of aircraft not being transferred (or novated) into deals following closing. In START III, the failure of aircraft to novate resulted in the asset count falling to just two aircraft from 19 initially, and six of 18 initial aircraft did not novate following closing in Lunar 2020-1. Meanwhile, the structures continued to pay note principal pro-rata and thus senior class A notes remained outstanding alongside class B and C notes.

This caused Fitch to downgrade the START III notes by multiple rating categories and the Lunar notes by one category, due to a significant increase in concentration risk that exacerbated the negative impact of the aviation sector stress. At YE 2020, all other aircraft had transferred into each transaction, so novation risk no longer exists for outstanding Fitch-rated ABS transactions.

If a breach of conditions specified in the asset purchase agreement occurs, the servicer and/or asset managers can opt to not transfer aircraft into a transaction. This non-novation event then results in a proportional paydown across senior and subordinate ABS notes.

Material novation risk, although occurring in only a couple of transactions to date, can be addressed in future new issuances if structures employ a POPs trigger that switches principal payments to sequential if a material number of assets fail to novate into deals, with senior notes paid down fully before subordinate notes receive any principal.  

Heightened concentration risks can occur as transactions amortize and assets are sold out of pools, leaving low asset count and less asset diversification (airline lessee, aircraft type/model, regionally/ individual country exposures) in the remaining pool.

Transaction POP waterfalls typically continue to pay pro rata unless performance triggers trip and/or certain events occur, and senior notes could remain outstanding later into a transaction’s life exposing them to concentration risk with potentially only a few assets remaining (e.g., less than five aircraft out of an initial 20). Similar to novation risk, this risk could be mitigated with additional structural protections for senior notes, such as triggers that switch the structure to fully sequential under certain conditions related to pool count and/or concentrations.  

Fitch-rated engine-backed ABS and certain esoteric ABS sectors switch to sequential principal allocation following the anticipated repayment date (ARD), with subordinate notes sharing principal distributions only before the ARD. Thus, in contrast to aircraft-backed transactions, the senior classes of these engine deals amortize at a quicker pace and are less exposed to concentration risks when pools have only a few assets remaining, which is a credit positive.