In February, the president signed an executive order focusing on regulating the U.S. financial system, which may begin the process of reconsidering or potentially undoing parts of the Dodd-Frank Act.
Airline profits have ratcheted higher over the past five years and investment-grade (IG) airlines have generated a five-year annual excess return that is 1.5 percent higher than the IG Corporate Index.1 Margins have risen sharply (Figure 1) and the credit profiles of the major carriers are generally stable. This period contrasts with the 2000s and during the financial crisis, when the industry was rife with bankruptcies and the major carriers were mostly high yield (HY). We take a look at what transpired and what the industry’s improvement may illustrate about economically sensitive Transportation credits.
In the early 2000s, airlines grappled with high expenses, a decline in tourism and a very competitive carrier market. The credit improvement since then has largely stemmed from consolidation that allowed companies to decrease expenses via labor cost rationalization and economies of scale. Roughly a decade ago, 85 percent of U.S. capacity (the number of available seats) was controlled by eight airlines: Delta Air Lines, Southwest Airlines, American Airlines, United Airlines, Northwest Airlines, US Airways, Continental Airlines and America West, per Morgan Stanley. Now, capacity is dominated by just the top four on that list. In addition, with fewer players in the industry, travelers have fewer carriers to choose from and airlines can more easily increase ancillary fees. Airlines for America (A4A) analysis shows that ancillary fees make up about 6 percent of revenues for domestic airlines and have increased 4 percent since 2010.
Airlines’ oligopoly structure has contributed to a more-favorable credit view of the industry from the ratings agencies. Airline credit ratings were knocked down several notches just preceding and during the financial crisis, but with the improved market share of the fewer carriers that are still standing, the airline industry is one of the only ones that is seeing rising stars at this point in the credit cycle. For example, Moody’s Investors Services upgraded Southwest Airlines to A3 from Baa1 on June 1; Delta Air Lines to Baa3 from Ba3 in 2016; and American Airlines to Ba3 from B1 in 2015. Also, in 2014, S&P Global Ratings initiated new ratings on regional airline WestJet at BBB-. This made WestJet one of the few IG carriers at that time partly due to its strong market position in Canada. (For a full explanation of the positive ratings and credit impacts of consolidation and size, see The Prize for Size in Investment Grade Companies).
Macro trends have also been a key support for airline improvement. Falling oil prices have pared down fuel expenses, while slow-and-steady economic growth has led to better industry “load,” which is a measure of how full planes are (Figure 2). While margins remain historically high, they have declined from their cyclical peak. That said, if oil prices increase above what we think is the sweet spot for airlines ($45- $60),2 carriers will be able to pass on some of those costs via ancillary fees, which adds stability to airlines’ revenue base.
The path of the airline industry highlights several themes for cyclicals.
Importance of Management Posture
The airline story shows how management posture is a major factor in the resilience of cyclical credits. In past economic and airline recovery periods, management teams of carriers have largely ramped up capacity – i.e., increased plane sizes and made more flights available – in line with improving macro trends. This time, managers have kept expansion at bay. For example, airlines increased capacity roughly 40 percent during the six years following the trough of the 1980s economic and industry cycle.3 By contrast, in the current economic expansion that began in 2010, airline capacity has been flat.4 Therefore, if the macro backdrop now turns, the industry will be less prone to overcapacity. Also, credit metrics have improved, as carriers have not taken on significant debt in recent years.
Management attitude also comes into play with airline customer experience. One downside of the recent consolidation and emphasis on cost cutting is that it may have contributed to the high-profile customer service complaints and viral videos that have surfaced around overbooked flights and poor customer treatment. Over time, airline management teams will need to better focus on customer experience to minimize reputational damage, which could have a material financial impact.
Importance of Looking Beyond Ratings Agency Reports
As the industry has improved, airline leverage metrics have become better than current credit agency ratings imply. Net leverage of airlines is now just under 2x,5 which is typically IG. By contrast, airlines are mostly rated HY. This shows that solely relying on the ratings to measure credit fundamentals could lead to missing out on industries or credits with potential for solid performance.
For exposure to HY airlines, one structure that IG investors can participate in is bonds that are backed by collateral such as equipment or leases. These structures, known as enhanced equipment trust certificates (EETCs), offer an additional source of funding for the airlines and were traditionally issued as a cheaper source of capital than unsecured debt. Investors concerned with capital preservation should consider EETCs in their investable universe. The four major U.S. airlines have $23.7 billion of EETCs outstanding, compared to only $6.4 billion of senior unsecured debt.6
We continue to perform in-depth financial research on all corporate bonds within our coverage universe, as well as monitor management character through our environmental, social and governance (ESG) analysis. While capital preservation is our highest priority, we can look beyond ratings agency reports and conduct financial and nonfinancial ESG research to potentially exploit market inefficiencies while seeking positive risk-adjusted returns.
 Bloomberg, as of July 27, 2017.
 Based on J.P. Morgan estimates, as of June 26, 2017.
 The 1980s airlines industry cycle lasted from roughly 1979 to 1989. Airlines were negatively affected by the global economic recession in the early 1980s. Source for capacity: The A4A Cost Index.
 The A4A Cost Index.
 Source: CreditSights piece “US Airlines 2017 Outlook: Still in Bond Heaven” from Jan. 5, 2017.
 Bloomberg, as of July 27, 2017.
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