Airlines Give Their Crown Jewels to the Bond Market
(Bloomberg Opinion) -- When the coronavirus pandemic brought travel to a standstill, airlines turned to every financing source they could find — even their previously untouched frequent-flier programs. Whether this is a positive development for the industry depends on who you ask.
United Airlines Holdings Inc., Delta Air Lines Inc. and American Airlines Group Inc. have raised more than $25 billion through debt deals backed by their traveler loyalty programs. American’s $10 billion offering, a combination of bonds and loans, was the largest ever for an airline and reportedly drew $45 billion in orders from yield-hungry investors. The carrier used the proceeds to repay a pandemic loan from the U.S. Treasury that carried more onerous terms. Spirit Airlines Inc. and Hawaiian Holdings Inc. raised an additional $2.05 billion backed in part by their loyalty programs.
It’s all the more incredible because no airline had tried to monetize its frequent-flier program in this fashion until the pandemic. On the face of it, this looks like an incredible feat of Wall Street ingenuity. United pioneered the financing vehicle with the help of Goldman Sachs Group Inc. after a separate earlier debt deal backed by aging aircraft had to be scrapped because of investor concerns about the value of that collateral amid a potential glut of retired jets. Frequent-flier programs, on the other hand, throw off a lot of cash and in theory tend to be less volatile than airlines’ traditional ticket revenue or the value of the underlying fleet.
All it takes is a quick glance at the yields on these bonds to see that investors think highly of loyalty programs. United’s MileagePlus debt priced in June to yield 7%, compared with the 11% yield that was floated in unofficial price discussions a month earlier, just as Warren Buffett said Berkshire Hathaway Inc. exited its stakes in a handful of airlines. In September, Delta issued eight-year debt that yielded just 4.75%. American’s eight-year bonds this month priced at 5.75%, which was due mostly to the recent climb in benchmark U.S. yields. The spread to Treasuries was just 20 basis points wider than Delta’s, even though Moody’s Investors Service rated American’s securities four steps lower.
Mileage credit redemptions declined by two-thirds at American in 2020, in line with the drop in overall passenger revenue, according to the company’s annual filing. But revenue associated with the marketing component of the frequent-flier program — defined as the use of intellectual property, including the American brand, advertising and access to the loyalty member list — fell by only about one-fifth. The average AAdvantage member has participated in the loyalty program for 10 years, and 40% of users have income greater than $100,000, according to a report from Raymond James Financial Inc. analyst Savanthi Syth. This type of stability helps explain why credit ratings firms are willing to give a higher grade to these debt deals than the companies themselves.
Loyalty programs offer “a lot of what’s good about the airlines without what’s bad about the airlines,” Syth said in a phone interview. But if the airlines are offering up their crown jewel to debt holders, what’s left for equity investors? Retail traders have piled into these stocks as the pandemic shows signs of easing: the U.S. Global Jets exchange-traded fund (ticker: JETS) surpassed $4 billion in assets this month, an increase of more than 2,600% from a year earlier.
Some airlines including Air Canada and Gol Linhas Aereas Inteligentes SA spun off their loyalty programs in an attempt to monetize these lucrative programs and create value for shareholders. But independent control of the frequent-flier programs created an inherent conflict of interest and deprived the airlines of some of the benefits of having these systems in the first place. The primary idea for the airline is to boost loyalty among customers, but independent programs may seek to maximize profit through the sale of mileage credits to third parties such as credit-card partners. So Air Canada reabsorbed its frequent-flier program in 2019 and Gol is trying to do the same with its Smile loyalty system. Monetizing frequent-flier programs through debt instead offers financial benefits without the operational headaches, but there is still a conflict of interest inherent in this transaction because equity holders have less claim to these lucrative assets.
“For an equity holder, even aircraft asset-backed securities are an issue,” Syth said. “If you can’t pay the bondholder, the aircraft will be taken away and there’s less value to you. The same assessment has to be made with these programs.”
Meanwhile, even bond investors have their limits. Mark Lindbloom, a portfolio manager at Western Asset Management, said his analysts were “very comfortable” with the yields offered in the United and Delta deals. He owns those bonds in the $38.4 billion Western Asset Core Plus Bond Fund. But the recent American bond sale came “at significantly reduced pricing — hundreds of basis points,” he said. “We’ve already seen that kind of compression.” Indeed, at one point earlier this month, the United debt that initially yielded 7% traded at just 3.09%.
It’s not uncommon for companies to mortgage everything but the kitchen sink in times of crisis. Ford Motor Co. infamously pledged its blue oval logo as part of the collateral for a 2006 financing package that helped it avoid bankruptcy in the Great Recession. But Ford reclaimed the logo and other assets in 2012. The difference here is that airlines are giving every indication that they see their loyalty programs as a more permanent means to raising capital. “It is sort of like a piggy bank,” Cowen Inc. analyst Helane Becker said in a phone interview. “They can tap it, pay it down and it’s there again.” She compared the loyalty assets to a supply-chain finance program.
Perhaps that’s fine, as long as there’s a market for airlines to supply. Airport checkpoint numbers continue to climb as more Americans receive their Covid-19 vaccinations in one of the clearest indicators that life is slowly but surely returning to normal. The benefit of the loyalty program debt deals for equity investors is that airlines have now proven they have more access to liquidity in times of crisis than previously thought, Syth said. But shareholders ought to be aware that airlines’ post-pandemic normal has an added wrinkle: Pledging some of their most prized assets to bondholders creates an under-the-radar risk that could one day come to the fore in an industry that’s had more than its fair share of brushes with bankruptcy.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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