New enhanced equipment trust certificates (EETC), a specialized form of aircraft-backed debt, have returned to the public capital markets after an almost two-year hiatus. United Airlines Inc. (BB-/Stable/--) recently issued $1.3 billion of Class A EETCs, the first such public issuance by a U.S. airline since 2021. Over the past few months, we have also raised the ratings on several EETC issues, driven primarily by the stabilization of certain aircraft valuations that led to lower-than-expected loan-to-value (LTV).

Aircraft valuations steeply declined from the outset of the COVID-19 pandemic, but improved industry fundamentals have limited (or stopped) the pace of declines.

Airlines are in the process of expanding their fleets of new, more efficient (and lower-emission) aircraft to varying degrees amid well documented supply constraints and surging passenger traffic (Chart 2). We believe a portion of capital requirements for new planes at some point will be funded with incremental debt. We presume EETCs will be included in the mix.

Debt structures across the airline industry are generally well diversified. Expected growth in unencumbered assets enhances funding optionality. Simply put, there is more collateral available for creditor security. The three largest U.S. carriers--American Airlines Inc., United, and Delta Air Lines Inc.--have historically accounted for the bulk of EETC transactions. We assume this will continue.

We acknowledge that visibility on the timing of EETC transactions is limited. We expect strong airline industry fundamentals to persist at least through this year. Estimated robust free cash flow generation within the sector is likely to limit near-term financing transactions. As such, we assume a corresponding increase in companies' capacity to fund new aircraft purchases with cash and no urgency (or need) to obtain funding. Moreover, sales and lease-backs have accounted for a greater share of aircraft financing, which reduces airline capital intensity. However:

• Demand for passenger air travel is highly cyclical. As such, the sustainability of free cash flow remains questionable, particularly if demand softens and aircraft manufacturer delivery delays materially ease.
• Most airlines target liquidity above the historical average to mitigate the financial risk of industry downturns/shocks. Presumably, this could reduce cash available to fund new aircraft purchases than what we otherwise expect.
• Debt maturities will need to be repaid at least in part with new debt that could include EETCs with either new deliveries or existing unencumbered aircraft.
• United just issued $1.3 billion in EETCs despite having one of the largest cash positions in the industry and the potential to fund much higher capital expenditure (capex) this year with internally generated cash flow. American has also publicly stated it would continue to finance aircraft and has the most EETC issues outstanding.

We estimate airlines we rate globally will generate positive annual free operating cash flow (FOCF) in aggregate over the next two years. However, we don't expect FOCF to recover to 2019 levels nor keep pace with much higher capex over this period (Chart 1). For several issuers, much higher capex could increase potential funding requirements, particularly if cash generation falls short of our estimates.

Chart 1

Status Of EETC Ratings And Industry Conditions

We raised the ratings on six American EETCs as well as certain United and Air Canada EETCs over the past few months. The actions have mainly followed stabilization of aircraft valuations that underpinned an improvement in LTV and corresponding increase in collateral credit. In contrast, we lowered several EETC ratings during 2020-2022, linked largely to our lowering of the underlying airline issuer ratings and weaker collateral coverage from eroding aircraft valuations.

We do not assign outlooks to issue-level ratings. However, we believe there is more upside than downside to EETC ratings over the next 12 months given:

• Our positive rating bias for underlying airline issuers (i.e., we have positive outlooks on the ratings on American and Delta); and
• The stabilization of aircraft valuations that could ultimately improve collateral coverage (and ratings).

S&P Global Ratings typically rates these secured instruments well above the issuer credit rating on the airline with creditor legal protections not afforded to non-aircraft-related secured debt instruments. Higher issue-level ratings often (but not always) translate into lower yields for debt funding. In our view, this is relevant given that our ratings on all U.S. airlines (other than Southwest Airlines Co.) are speculative grade. The airlines generally have greater sensitivity to funding costs.

Chart 2

Much stronger supply/demand conditions for aircraft this year is indisputable. Airlines are materially expanding capacity this year and expect to capitalize on stronger passenger demand that shows no signs of easing. In addition, the supply of new aircraft remains constrained by manufacturer delivery delays, namely from Boeing Co. and Airbus SE. Several significant orders were placed over the past year, more are likely, and backlogs extend well into the next decade. Narrowbody aircraft were the initial beneficiaries of improving market fundamentals, as domestic (shorter-haul) traffic reached pre-pandemic (2019) levels at the end of 2022. More recently, the reopening of long-haul, international markets has reignited demand for widebody aircraft that fell out of favor during the pandemic.

An Update On EETC Scoring

Our EETC ratings are primarily a function of an airline's issuer credit rating as a starting point, in addition to affirmation credit and collateral credit component scores. They can be influenced by a variety of factors such as legal assessment, liquidity provider rating, and comparable ratings analysis modifiers (Chart 7). Most EETC ratings are higher than the underlying airline issuer credit ratings. We believe it is helpful to summarize some observations from the component scores of our existing ratings.

Affirmation credit

Most of over 50 EETC issues rated by S&P Global Ratings include three to four notches of uplift for affirmation credit. This mainly reflects the high proportion of issues that have priority rankings to other subordinated tranches within an EETC (that is, all AA classes and most A classes). Affirmation credit scores also incorporate our view of:

• The high likelihood for airlines to affirm the EETC after a bankruptcy filing (or similar event); and
• The very high likelihood of an airline reorganizing for most rated instruments.

AA classes, the senior-most tranche of an EETC, typically receive an affirmation credit score of '4'. For A class tranches that have a '3' score, this usually reflects their ranking behind an AA class tranche in the same EETC. The impact of subordination is most apparent for B classes that have the highest share of affirmation credit of '2' or lower (Charts 3 and 4).

Chart 3

Chart 4

However, subordination is not the only consideration when assigning affirmation credit.   For example, certain senior-ranking A tranches with no elements of subordination have scores of '2' and '0'. These scores incorporate our view of the lower (medium or low) likelihood for the airline to affirm the EETC after a bankruptcy filing (versus high for most EETCs that we rate). This typically results from an EETC tranche that has a very high LTV and/or aged and less desirable aircraft within the collateral pool. For example, we do not ascribe a high likelihood to affirm tranches that have LTV above 85%, and this constrains our affirmation credit and final ratings.

Collateral credit

There is far more variability in collateral credit than affirmation credit. A larger range of possible outcomes--from '0' to '7' (versus '0' to '4' for affirmation credit)--is partly responsible, as well as the high sensitivity to changes in LTV that impact scores. Collateral credit is essentially based on the LTV of a EETC tranche for a given collateral assessment (which reflects technological risk, resale liquidity, diversification and aircraft age). In general, higher LTV lead to lower (or no) collateral credit.

The underlying principal amount of an EETC will amortize over a defined period that does not change following transaction close. As such, changes in collateral credit tend to follow updated third-party collateral appraisals that depart from our assumptions (which we base on annual depreciation estimates). We include rating uplift on 100% of AA classes and 80% of A class EETC tranches from collateral credit. This is not the case for B class tranches, of which 60% of tranches receive no collateral credit (Charts 5 and 6).

Chart 5

Chart 6

Total Notching

We rate most EETC classes multiple notches above the underlying airline issuer credit rating.   This is most apparent for AA classes, of which all receive at least seven notches of rating uplift due to a combination of affirmation and collateral credit. Of the 10 AA classes we rate, five (50%) receive nine notches of uplift and two receive 10 notches of uplift: American's 2016-3 Class AA and 2019-1 Class AA EETCs. We rate these issues 'A' (compared with the 'B-' issuer credit rating on American).

A class tranches account for the largest share of EETCs we rate, with well-distributed rating uplift (similar to the distribution of collateral credit, noted above). Most (63%) of total A classes rated receive four to six notches of rating uplift. There is one outlier that does not because of our view of the low likelihood that the airline will affirm the EETC in bankruptcy and high LTV (which leads to no collateral credit).

Perhaps not surprising, B classes receive the lowest rating uplift from collateral credit relative to senior AA and A classes. About 43% receive a '1' collateral credit score. However, scores are well distributed, with a few instances of five to six notches of uplift that reflects a secondary claim (rather than third-priority claim) on collateral, and relatively modest LTV.

Table 1

Table 2

Watching For When Airlines Issue More EETCs

We don't know when airlines will launch new EETC transactions, but we expect they will remain a part of airlines' prospective financing plans. Strong order backlogs and rising capex budgets globally suggest the appetite for new aircraft will remain strong for several years. An expanding fleet of new planes will increase capacity for secured financing. The strong near-term outlook for passenger airlines' cash flow limits the imminent need for large-scale financing transactions. However, airline industry fundamentals will remain cyclical. As such, the ability for most issuers to generate free cash flow on a sustained basis remains largely uncertain. In our view, funding gaps that arise from heightened aircraft purchases could be met at least in part with EETCs.

Appendix

Chart 7

Recent Research

• Several American Airlines Inc. Enhanced Equipment Trust Certificates Ratings Raised, July 12, 2023
• United Airlines Inc.’s Series 2023-1 Class A Pass-Through EETCs Assigned ‘A (sf)’ Rating, June 20, 2023
• United Airlines Holdings Inc. Upgraded To ‘BB-‘ From 'B+' On Strong Credit Measures; Outlook Stable, March 28, 2023

Related Criteria

• Criteria | Corporates | Industrials: Methodology And Assumptions For Rating Aircraft-Backed Debt And Enhanced Equipment Trust Certificates, May 26, 2021