I previously wrote up a hodge-podge of ideas I consider highly attractive at the moment, for those with a multi-year holding period and not beholden to the margin clerk (see here). I also mentioned there is a TON of interesting stuff out there at the moment, across the capital structure; the Aercap junior subordinated perps are one of the more compelling near-term investment propositions I have seen of late.

Aercap junior subordinated perp bonds (5.875 ’79) – 60/61, ~10% running yield

Everyone knows I love Aercap (NYSE: AER) and own the common stock (see here). Despite its travails of late (and my terrible timing in adding to the position), I think it’s quite likely they make it through the crisis, not only surviving, but thriving. Still, the junior sub bonds (I will refer to them as ‘prefs’ since functionally they look much more like preferred shares) offer a less high-octane way to play the entity surviving in some form over the next couple years, whilst still offering an eye-popping total return (near a double) if or when business normalizes.

These bonds ($750mm outstanding) are junior to most all outstanding AER debt (around $29bn) but senior to the common equity (around $9.5bn). They trade around 60c (having traded as low as <50c a few weeks ago, and were well above par a month ago). Here’s the description from the 20-F:

So, AER has the right to turn off the coupon at their discretion, and then not pay those coupons back later on (that is, it is ‘non-cumulative.’) However, if they wish to repurchase shares of the common, they have to be paying the coupon on this paper (not mentioned in the above but a key detail included in the pref prospectus). Whilst 2020 may be a terrible year, AER had already repurchased some stock in the first quarter, so the 1H distribution is thus safe (that is, close to 3pts of principal); but I do expect the 2H distribution to be turned off. Nevertheless, since AER will be keen to return capital via repurchases as soon as business returns to normal, I fully expect the company to turn the coupon back on from early 2021 (or simply repurchase these notes in the market as another form of capital return). So lost income should really only be 3-6pts and shouldn’t change the return profile of this investment massively (since we are buying at 60 and hope it goes back to par).

It is also worth mentioning that the coupon resets every 5yrs to the 5yr treasury rate plus a spread (this implies about a 5pt coupon, or a 9% running yield, from 2024). Of course, the implication is that owning this is inflation protected – since if rates rise dramatically (something I think could well happen as the government prints endless amounts of cash and runs huge deficits through the crisis), your coupon will also rise. The company has the option to repurchase the bonds, at par plus accrued, concurrent with any rate reset – and thus I think there is embedded optionality this far below par where in any higher interest rate environment, AER is much more likely to retire these securities than leave them outstanding if 5yr rates normalize at something like 2-3%.

Still, the main risk associated with this instrument is that AER either has a liquidity crisis and files – in which case your recovery would not be dissimilar to common equity, that is, very low – or that the equity cushion beneath you is massively eroded through book value impairments (as their airline customers progressively file bankruptcy, reject leases, and AER is unable to place the returning aircraft with alternate customers) such that these prefs end up trading much like the equity and at a deep discount to book.

But how deep is deep enough? These already trade at 60c of face – implying $450mm value and, therefore, a ~$10bn implied book value hit to the core fleet ($9.6bn of equity value wiped plus the $300mm of implied pref write down). As of Dec’19 the book value of the fleet was $36.5bn, and AER had successively sold assets at a 10-15% gross premium to  asset value for the last ten years. This WSJ article suggests aircraft values have already fallen 5-15% and may continue to fall further. If replicated across AER’s book, it means current book value is probably in line with aircraft trading values, in toto. But current market prices of the prefs – that imply a further $10bn hit to book, as discussed – suggest a further 27% hit to aircraft values (and thus in sum a 35-40% write down from month ago levels), immediately; across the entire book; with no offsets for maintenance/security deposits, or interim earnings.

That seems ridiculous to me, especially in the context of airline and OEM behavior: both of whom are rapidly reducing aircraft supply and in ways that support the value of newer next-gen planes. For example American Airlines and Lufthansa have been quick to announce fleet reduction plans, the cornerstones of both have been the retirement of 1) very old planes (to lower service cost); and 2) the retirement of legacy technology aircraft that have minimal demand in the market (A340s, B747s, B757s, B767s, A380s). Moreover, the reductions are coming from their OWNED fleets first – that is, where they can simply stop flying; it makes no sense to remove planes still on lease whilst they have to contractually pay the lessors. Whilst AER does have some older planes in its fleet, they have precious few of these categories of planes, and the older planes are overwhelmingly in the ‘high-demand’ plane varieties (A320s, B737s) that will be the last to let go (A320s, A330s, B777s), if at all. At the same time, AER has almost zero exposure to the Max – an airplane that may well simply disappear from the skies, a casualty of idiosyncratic issues compounded by COVID-19:

At the same time, the OEMs are cutting production to preserve at least some supply/demand balance. Airbus is reportedly curtailing the production rate for its A320 aggressively; and Boeing has been progressively cutting wide body production rates as well. Since the OEMs have more to lose than anyone else (airlines or lessors) by seeing new plane valuations falls aggressively, it stands to reason that lower new-build production will be a sustained feature of the environment as long as demand remains low. And meanwhile, we will see a huge number of the older fleet progressively scrapped (following the Lufthansa and American examples).

All of this is not good news for the near-term demand environment but it is comforting for the paper essentially backed by newer aircraft residuals – and in particular, I believe, these prefs. The return profile from here looks compelling – if AER can simply prove they are liquid enough to last 1+ years (something I think gets accomplished at the upcoming earnings report); and that their unencumbered assets can be readily collateralized in the current environment, I could see these trading back to the 80 level. Meanwhile if or when the demand environment improves – even if a year from today, as we approach a vaccine, I think these can fully recover par and trade on a 5-6% yield. Such a move would entail close to a 70-75% total return (one half coupon plus capital return) for an instrument I think has exceedingly low permanent capital impairment risk.

Disclosure: long AER common stock and 5.875 ’79 prefs