The airline industry, currently subject to an extraordinarily challenging trading environment, could be about to save billions of dollars every year in financing costs if a new set of benchmarking indices rally market support.
Skytra, a wholly-owned Airbus subsidiary, has recently received approval from the Financial Conduct Authority (FCA), making it the sole regulated Benchmark Administrator for the world’s first Air Travel Price Indices.
The six Skytra Price Indices, covering the global airline industry, will enable the market to use its regulated benchmarks – based on US$ per delivered passenger kilometre – to price derivative contracts, and provide an effective hedging solution against airline revenue volatility.
Airline industry is debt heavy, and pricing volatility has a serious impact on its cost of capital. However, reducing revenue volatility by hedging the value of ticket prices could be worth up to $7.7bn in savings per year. This would be achieved if the industry gains just a single notch improvement on its cost of financing – a notch is the shift up or down by one place of a rating given to a specific issuance by a credit ratings agency (CRA).
Other industries providing ‘non-storable goods’, and which practise yield management, such as travel and tourism, and mass transportation, could benefit from similar indices.
Elise Weber, Skytra co-founder and Chief Sales & Marketing Officer, told TMI that although airlines currently reduce volatility on risks such as fuel prices, exchange rates and interest rates by hedging, there has never been a financial instrument to reduce volatility on ticketing revenues, which she says is the largest position affecting their profit and loss statements.
Current difficulties created by the pandemic have thrown the sector into a financial tailspin. According to the International Air Transport Association (IATA) Annual Review 2020, travel restrictions reduced global demand for flights by around 60% in 2020. Airlines emerging from the crisis “will do so with higher levels of debt and with a higher cost of debt”.
Total aid for airlines in 2020 amounted to about $173bn. IATA reports that more than half of this is deferred debt or payments that will need to be reimbursed as the industry tries to recover.
The cost of debt financing is therefore a growing problem for the aviation industry, which is labelled by CRAs as a cyclical transportation industry, with resultingly lower credit ratings and higher cost of capital than other more revenue-predictable sectors.
With the effects of the pandemic ongoing, there has been a dramatic downward shift of equivalent revenue-weighted credit ratings across the industry. These have slipped from around 30% investment-grade pre Covid-19, to only 4% as of November 2020. A further 64% of airlines are now C-rated by the major CRAs.
Financing costs are, for many airlines, increasingly challenging. This has a knock-on effect across the industry. For Airbus, the difficulties airlines have been having in buying its aircraft in recent years is all too apparent, which is why Skytra was conceived around two years ago.
Although on the cost side of running an airline some clarity exists, with volatile aspects such as fuel and foreign exchange (FX) being commonly hedged, there is little visibility over long-term earnings before taxes and interest (EBIT) margins, explains Weber. By enabling hedging of both sides, margins become more predictable and, resultingly, credit costs lower.
Although transportation is a ‘non-storable good’, the Skytra team noticed that in the dry-bulk shipping sector it is possible to hedge the cost of hiring the vessel, giving a precedent for hedging transportation price risk. By creating indices that offer standardised measurements of the price of air travel for different regions, all airlines can use it as a hedging benchmark.
With six indices covering the regions, Skytra publishes daily averages for US$ per delivered passenger kilometre, to which the world’s airlines can corelate their own revenues. Twelve airlines worked with Skytra over two years to ensure high correlation, says Weber. Now, with FCA approval for the indices granted, all other airlines can begin hedging their EBIT margins as a complement to their commodity hedging programmes.
To do so requires the treasurers of these airlines to undertake the correlation analysis, consider the financial instruments they wish to use, update their risk management policies, and work with their banks to agree on and place the hedges.
It is likely that only the largest institutions will be involved as counterparties, notes Weber. She adds that Skytra has been working with “all the major banks” covering the aviation sector to familiarise them with the concept. The expectation is that the first hedges using the indices will be placed in the next couple of months.
Skytra has also been in consultation with a number of major corporates that have large travel budgets. When air travel picks up again, those that have been observing prices will have seen increases of between 50% and 200%. “Even if volumes remain low for some time, the need to protect against volatility has increased because of these extreme price movements,” explains Weber.
For major travel buyers that want to plan travel budgets for the end of this year or for next year, mitigating big swings is precisely what hedging will do. “We’re engaging with them, and the industry bodies, to explain how the concept works,” she says.
With Skytra’s sole purpose to provide benchmark data, having attained FCA approval it will now be selling licences to a wide range of market participants, not just airlines, Weber confirms. Buyers, sellers and their banks can now begin to explore hedging deals. And, with ticketing transparency and predictability made visible through the indices, she adds that index data could soon also become a valuable negotiation tool on both sides.
What’s more, any industry that undertakes yield management, and which may be facing similar volatilities, could build an index of this kind, providing it can pull in the right data. This could include hotels, cruise lines and other mass transportation sectors such as rail and road transport.
Engaging CRAs in discussion on how reducing earnings volatility might impact ratings gave Skytra sufficient qualitative data. But it needed quantitative data to demonstrate to treasurers and CFOs that this new form of hedging, including the adoption of the Skytra indices, would be worthwhile.
Research on the impact of reducing cash flow volatility on credit ratings was conducted by Regis Huc from Toulouse Business School. Huc explains that while CRAs use earnings volatility as part of their assessment, much of what they use is qualitative. However, earnings volatility implicitly sets up the interest coverage ratio that leads to a particular rating (the ratio measuring how many times a company can cover its current interest payment with its available earnings). But a business with stable revenues, such as a utility, is not required to achieve anywhere near the same coverage ratio as an earnings-volatile airline in order to attain the same rating.
To understand the link between earnings volatility and credit ratings, and to validate the outcome of a single notch improvement, Huc used a combination of two methods. First, he investigated the cost of a notch for each credit rating, applying this value across the credit rating spectrum of the whole airline industry. Second, he used a theoretical model, Emery’s Lambda (a tool that can be used to gauge a firm’s liquidity) to link earnings volatility and default probability, and its implied effect on credit spreads.
He determined that the airline industry in 2019 had debt of around $700bn compared with revenues of around £850bn. By calculating the actual level of financing cost, and estimating the credit rating of the industry, he arrived at a debt distribution in the industry per credit rating.
Some of the available data was rather unrefined, spreads being more difficult to interpret towards the lower end of the spectrum. However, having corrected for probability of default, a cost of finance per rating was calculated using previously published S&P data.
The average cost per notch was then worked out at around 20 to 25 basis points: the higher the credit rating, the lower the notch value. Given the interest spreads relative to credit quality, a single notch improvement will naturally have more impact at the lower end of the credit spectrum and, says Huc, with many airlines having slipped in quality, improving credit by one notch is a big deal.
‘How reducing airlines’ revenue volatility could reduce their cost of financing’ can be accessed by emailing Skytra on [email protected].’