Article by Dean Argent

This article discusses how Islamic Finance is being deployed to finance the acquisition of Airliners (such as Boeing and Airbus aircraft) that are placed under long-term leases. This High Yielding Alternative Investment Class is the new buzz within the Islamic Finance community.

As a result of the Global Financial Crisis and Eurocrisis, conventional aircraft financing sources have dried up for now. But with its long-term predictable income, growth forecasts and suitability for Islamic Financing, an immense market opportunity now exists for savvy Islamic Finance investors.

Islamic finance is growing fast. Over the next decade, the Islamic Capital Markets is expected to sustain double-digit growth to almost USD1 trillion in 2020 with CAGR of 10.6%. In 2000, there were MYR39.6 billion in Sukuk issues. In 2010 it had grown to MYR294 billion and the Malaysian Securities Commission expects further growth to a staggering MYR1331.5 billion by 2020.

The Sukuk market has been quite resilient during recent instability in global financial markets which is making conventional bond issues difficult. The resilience is a result of the Islamic investors remaining cash rich; partly due to limited supply of Sukuk; and partly since Sukuk investors tend to hold the bonds until maturity, reducing the chance of big swings in secondary market prices triggered by shorter-term speculators bailing out of positions.

No matter what the reason, Aircraft Lessors are now turning to Islamic financing to support their aircraft acquisitions and those lessors backed by Islamic Finance are growing at astronomical rates.

The aircraft leasing industry is relatively new, with the first aircraft lease recorded in the 70's. Now, around 40% of the world's aircrafts are leased. According to Boeing, 35% of the USD4.5 trillion in new aircraft deliveries over the next 20 years will be delivered to Asia – which is the global number 1 hotspot for aviation growth.

Couple this immense market opportunity with the emergence of Labuan as one of the most competitive jurisdictions in the Asia Pacific region – along with aircrafts' compatibility with Islamic Financing methods - and you have the making of the next explosive growth industry.

Despite its recent rapid rise in popularity, Islamic financing for aircraft transactions have been around for a while, here's just a sample of some large Islamic Finance transactions:

  • In 2005, Emirates issued a USD550 million Sukuk bond and repaid it in full during June 2012.
  • In 2008, Etihad won airfinance journal's deal of the year for an Airbus A340-600 purchase from Airbus supported by Islamic finance (circa USD140 million).
  • In November 2009, GE sold USD500 million in Sukuk against existing aircraft.
  • In July 2010, Nomura sold USD100 million in Sukuk against existing aircraft.
  • In June 2012, the Malaysian Finance Ministry sold MYR5.3 billion of Islamic bonds to finance 6 x Airbus A380s and 2 x Airbus A330s for lease to Malaysian Airlines.
  • In June 2012, Malaysian Airlines sold MYR1 billion of Islamic bonds.
  • In September 2012, Malaysian Airlines sold a further MYR500 million of Islamic Bonds.
  • In October 2012, Turkish Airlines is well progressed in a multi billion Sukuk issue to finance the purchase of aircraft to double its fleet over the next 10 years.

Alafco, the aircraft leasing arm of Kuwait Finance House, employs Islamic Finance techniques to acquire their aircraft fleet. It is one of the fastest growing aircraft leasing companies in the world. In 2011, it had 105 firm orders with Boeing and Airbus – the second largest order book of all lessors on the planet.

Media reports are commonplace describing Dubai's Emirates airline investigation of Islamic Financing to fund their aircraft deliveries in the wake of the Eurozone Crisis. Malaysian Airlines is at the forefront of innovation in the Islamic Capital Markets when they were the first ever corporate issuer of a Perpetual Sukuk in June this year. The MYR2.5 billion programme was fully subscribed, with the first subscriber at MYR1 billion.

The proof is irrefutable. Islamic Financing as a method of acquiring commercial aircraft is the fastest growing financing method in the industry, and it's growing exponentially.

The power houses of the Asian banking sector are on a mission to internationalise Islamic Financing. In Bank Negara Malaysia's Financial Sector Blueprint 2011- 2020, the key recommendations regarding Internationalisation of Islamic Finance are as follows:

  • Increase the diversity of players in the domestic Islamic financial industry to support a wider range of financial products and services that serves the best interest of Malaysia.
  • Support the growth of the Islamic fund and wealth management industry in collaboration with relevant authorities.
  • Enhance the dynamics of the Islamic money, foreign exchange and capital markets.
  • Increase market efficiency by facilitating the use of standard documents and agreements among financial market players.
  • Promote active participation in issuance and trading of Sukuk.

So the stage is set. The timing is right, the place is Labuan and investments in Commercial Aircraft as an alternative asset class is rapidly growing.

But there are some restrictions. Islamic finance must comply with various requirements of the Shariah including the prohibition on Riba (which includes interest). And there are some major transactional structure differences between financing leased aircraft with Conventional Finance vs Islamic Finance. The end result however, is the same, that is, the lessee ends up with the right to quiet enjoyment of the aircraft for the agreed period and the economic responsibility of the asset is passed to the lessee for the lease term.

Under conventional financing methods, the lessee pays a monthly rental fee in advance plus, it also pays Maintenance Reserve payments to compensate the lessor for the maintenance utility consumed by the lessee. But to achieve compliance with Shariah, the transaction must be structured differently so that the lessor remains responsible for major and structural maintenance, hull and equipment and ownership taxes. But airlines are in the business of operating aircraft and they must have a maintenance capability. Conversely the financier/lessor is not normally in the business of operating or maintaining aircraft, so it is common for the lessor to appoint the airline/lessee as its service agent to complete and fund for those expenses.

The lessor as principal must repay those costs to the Lessee/service agent, and the rental payments are increased accordingly. But, these payment obligations and the extra rent are offset against each other and this effectively passes the economic responsibility of the aircraft to the lessee.

Risk mitigation

To protect the Islamic financier from the inherent risks that come with ownership of a financed asset, a Special Purpose Vehicle (SPV) can hold the aircraft subject to a Mudaraba (an investment management agreement) and the SPV becomes the Mudarib (the investment manager) and the financier becomes the Rabb-ul-maal.

Under the Mudaraba financing model, the investors pass their funds to the Mudarib for it to use in accordance with the investment plan. The Mudarib must have a share of profits (which can be small) and will not be responsible for losses unless caused by its negligence or default. While the legal nature of a Mudaraba must be tested under local law, interposing the Mudarib as the lessor and legal owner of the aircraft can create some distance between the Islamic financiers and ownership risks.

Features of Islamic financing of commercial aircraft

Diversification of funding sources. Until recently, Islamic Financing has not been considered a mainstream alternative to conventional finance. Coupled with conventional-style documentation, bankable governing law, the ability to combine with conventional funding sources and a new market has opened up.

Sukuk holders are investors not creditors. The relationship of Sukuk holders to issuer is that of investor, not creditor. The Sukuk holders are joint owners of trust assets, being aircraft (subject to leases), the lease revenues and lease rights. They exercise their rights as owners through a Sukuk agent, who has the authority to enforce lease rights, and can be compelled to do so by relevant proportion of Sukuk holders.

The Sukuk holders' rights against the Issuer are limited in recourse to the trust assets – normally being the aircraft itself. The complexity of each transaction is dictated by the investor/rating requirements. For example rating agencies such as Standard Poor's, Moody's, Fitch apply conventional rating criteria, to which Shariah compliance is not relevant. This allows minimal reliance of the performance of Ijarah because the rating agency is more likely to focus on other issues such as level of over-collateralisation, bankruptcy protection, quality of the asset and its liquidity.

Under Islamic Financing arrangements, the standard ingredients include Aircraft Management and Remarketing Agreements, removal of the lessor from other transactions for bankruptcy remoteness and establishment of the lessor in a tax-friendly jurisdiction.

Aircraft lessors' requirement for Islamic Funding seems likely to outstrip conventional funding sources available due to huge aircraft orders and need for specialised appetite for regional risk. The recent run of innovative Islamic aircraft financings have helped develop Islamic aircraft financing technology, while non-airline sukuks and airline bonds have established investor appetite for this asset class.

If you are seeking long-term predictable returns – without correlation to the equities markets – then investing commercial aircraft using Islamic Financing could be right for you.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.