Regular readers will know two of my deep loves are aircraft leasing and short-duration, yieldy paper 🙂 Rarely do I find the chance to combine these twin desires – and yet in Fly Leasing (NYSE: FLY) Nov’21 bonds I think I’ve found one such opportunity. These FLY bonds are at 91/91.25, yielding 15% to maturity in just over a year. They are unsecured and sit behind a VERY large stack of secured debt (but ahead of ~$900mm of book value in equity). The company makes it easy for us by providing a quarterly debt stack; I have added a couple of annotations that I think are relevant too:

There are a few moving parts to the thesis but at its core this is a ‘pull to par’ trade – that is, I don’t own these bonds because I am wildly bullish on the long-term aircraft leasing outlook (even though I am), or FLY’s risk exposures in particular (which I’m not). When you are buying extremely short-dated subordinated instruments you need to worry less about the mid/long-term sustainability of the cap structure, and more about the burn-down cashflows between now and maturity. In this case, I think the FLY bonds are basically refinance-able based on near-term cash flows alone (let alone tapping into unencumbered assets or more non-traditional sources of liquidity), but there are other idiosyncratic factors at work here: the amount of debt ($325mm) is extremely small relative to the total debt stake ($2.2bn); and the total capitalization ($3.1bn). All else equal, it is generally not small issues that tip over large capital structures – especially not when there are incented owners of the equity calling the shots beneath you (more on this later).

However, the meat and potatoes of the investment thesis here is simply that FLY generates enough cash in the near-term to almost refi these bonds without resorting to extraordinary measures. Let’s take a look in detail at how I came to this conclusion. Firstly, take a look at the simplified PnL from the last few quarters below. You will note that I have removed all ‘non-cash’ items from the PnL (eg depreciation, debt extinguishment, etc) and also all non-recurring items (no aircraft sales gains, etc) – since the goal is simply to work out what cash FLY is generating from the core leasing business in the current environment. The result looks like this:

I would posit a few immediate observations regarding the above:

• the core ‘cash profit’ from the business is around $50mm, even in the most recent period (remember this excludes receivables build however);
• debt principal repayment through 1Q’20 in particular was the main use of cash;
• on my 2H numbers, assuming status quo per 2Q (fairly punitive as more airlines get back into the air as time goes on), 2H cash flows will be much better than in 1H – mostly because debt principal repayment for the year is basically done.

That is to say, if it weren’t for payment deferrals (going into receivables build), FLY would be generating ~$50mm a quarter pre-tax, even in the current environment. Since the company has guided that lease deferrals bottomed out in 2Q, and will be at de minimus levels from 4Q, this is likely a non-issue going into 2021:

Let’s step back for a moment. The company today has $290mm in unrestricted cash, and per my above analysis this number is likely closer to $350mm at year end (allowing for the current deferral schedule and schedule debt principal amortization per the 20-F). At this point – early 2021 – the company will then likely assess how it will tackle the 2021 debt amortization schedule, which looks like this:

$566mm in principal repayment looks a little daunting, but let’s break it down. Obviously $325mm is our bond – the largest obligation – and this will need refinancing. But the rest of the stack is secured ($240mm), and more importantly, a good chunk of it is non-recourse (the Nord LB Facility, $60mm; and the Fly Aladdin Facility, $25mm). This is not to say you cannot make those principal repayments – but simply that FLY could hand back the relevant aircraft and not repay those (or future) obligations if they really wanted to, since lenders would have no recourse to FLY (and thus there would be no cross-default on FLY secured debt or our unsecured bonds)…

Of course I don’t think it comes anywhere close to that. Recall that the business will be generating ~$50mm in core cash profit per quarter entering 2021, when deferrals will drop almost to zero (and actually turn into cash inflows as airlines get current). Note that there is an added wrinkle of some aircraft coming off lease sequentially through 2021 (about 7% of the fleet). But the basic conclusion is I think FLY could meet the amortization profile on secured debt through cash generated by the business, in the current status quo, alone. This is the key point since it means the bulk of the unrestricted cash ($350mm) and unencumbered assets ($600mm) can be used to repay/repurchase our bonds.

(A quick note on the unencumbered assets: there is zero clarity on what these constitute. They could be planes, but they could also be equity interests in structured finance vehicles; or maintenance rights, etc. There is no doubt some value to them but if I were to rely on them for liquidity, I would use a VERY steep haircut to the $600mm theoretically available (definitely greater than 50%, maybe more), and, thus, I am not comfortable using this pool of assets in assessing whether these bonds can make par or not).

Of course, this is somewhat of a theoretical discussion, as the company is likely to pursue some kind of refinancing of the notes well in advance of maturity – I think as soon as the end of this year or very early next year. Of course this is dependent upon many things – the state of the virus and whether a vaccine is near; the price of the bonds; whether more deferrals have been required; whether any large clients have defaulted, etc – but all else equal management has already commented on a desire to do something with the bonds, even buy them back in the market with excess liquidity:

In addition to the pure burn-down cash flows and liquidity picture, there are of course the idiosyncratic issues I alluded to earlier. There is a strong incentive for BBAM – the outside manager who runs FLY’s leasing and trading operations, for a fee – to see FLY equity continue to exist (not just for the fee stream, but BBAM’s shareholders own 23% of FLY’s equity directly). Keep in mind that BBAM’s major shareholders are GIC (the massive Singaporean investment institution), Onex, and Summit – all organizations with substantial resources and long-term perspectives and incentives. This means, if worst comes to worst, there is a reasonable non-zero chance that BBAM (through its owners or directly) would provide a hundred million in financing to roll these bonds to protect their equity investment, even on harsh terms – but as owners of the short-dated instrument, we don’t care about that, we just need these bonds rolled.

Other risks and things worth thinking about

As with any investment there are risks, of course. Since this is a very near-term refinancing, there are really only two I worry significantly about: a major customer bankruptcy; and covenant breach on the secured debt.

Major customer bankruptcy: one of the major knocks on FLY as a business is that they are quite concentrated, with chunky carrier risks in ‘interesting’ geographies. Here is the mix as of 2Q:

Air India is the scariest on the list – but these rents are actually guaranteed by the Indian government, and so are in this case money good. Otherwise, Philippine Airlines and Malaysian have both gone bankrupt previously, and are in a fairly parlous condition now (although the billionaire behind Philippines, Lucio Tan, continues to pump new capital into the company, per press reports). AirAsia is stressed, but appears close to doing a rights issue that will tide them over for at least a year. There is not much information available about how close to the wall Malaysia is. Meanwhile, despite the geography, Ethiopian is actually one of the stronger airlines in Africa – this exposure is probably fine (in any case most of FLY’s exposure here is via freighters, which have clearly been doing very well post-COVID).

I think FLY is probably OK, and these bonds too clearly, if one of their major clients filed – but things would get quite hairy if two filed. I realize that is not a very scientific analysis, but what gives me comfort here is given the state of play, both with regard to air travel bouncing off the bottom in 2H; and with vaccine progress quite likely by year end; and the fact that these bonds will likely get refinanced in a matter of months – that is, before conditions potentially deteriorate further at some of these airlines.

As for covenants on the secured debt – the main risk I think is violating the LTV covenants (around 70-75% for each tranche) in the event plane values get written down aggressively (there are precious few covenants on most of the secured tranches beyond this, and a debt service coverage ratio covenant that looks quite easy to meet on the Fly Aladdin facility). However, again, these writedowns are likely only a factor post year-end auditing, which will be reported in February or March – and once again I expect these bonds to have been bought back/tendered for/refinanced in some other way well and truly in advance of this date.

Thus, whilst you need an inherent sanguine view on the recovery in air travel, I do like these FLY bonds at 15% YTM and barely a year to go to get paid. In fact given how I see this playing out (bond bought back/tendered for and refi’d inside 6months at/near par) I think there is a good chance you can generate at 20% IRR on these bonds with little risk of permanent impairment. That’s good enough to get into my short-dated carry bond book. But caveat emptor, always!

Disclosure: long FLY ’21s (also long AER stock and ’79 prefs)

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