Staying Aloft

Marilyn Cohen, Forbes Magazine, 06.11.01

It's topsy-turvy time in bondland. Issuers like Motorola and Lucent are barely hanging on to their investment-grade ratings and outyielding some B-rated junk issues. Credit quality is spiraling down. According to Moody's, this year we've seen the largest number of investment-grade companies relegated to junk status since 1990's first quarter. There are more to come.

Moody's says that when companies file for Chapter 11 these days, the bondholders recover about 16.5 cents on the dollar. Good-bye to the days when recoveries ran 50 to 70 cents on the dollar.

What's a bond investor who wants to sleep nights to do? One answer, detailed in my Mar. 19 column, is taxable municipal bonds. Here's another: enhanced equipment trust certificates (EETCs).

These securities, available for the past seven years, are mostly used by airlines to buy planes, which are the collateral. Issuers include Delta, United, American, Northwest Air and Continental, as well as package shipper Federal Express. The carriers are updating their fleets these days, so more of these bonds (whose maturities range from 7 to 18 years) will be around for you.

Liquidity is high and yields are juicy-160 to 185 basis points more than Treasurys of comparable maturity. That's not bad, given that the collateral is pretty solid. When an airline goes under, its fleet still has considerable value and holders of these certificates have first claim on those assets.

The issuers have taken to slicing the collateral even finer than this. There are separate "tranches" of credit standing for the EETCs covering one airline fleet, giving a pecking order to certificate holders in the event of financial trouble. Indeed, the "enhanced" in the name is a reference to this credit slicing.

You can buy the United Airlines EETC with a coupon of 7.2%, due April 2011, Class A-2 tranche, rated AAA by Standard & Poor's at 98.5, yielding 7.4% to maturity. Contrast that to an unsecured issue with roughly the same maturity: the UAL 9.1% due January 2011, rated BB+ by S&P on credit watch for a downgrade. It's priced at 98 to yield 9.4% to maturity.

The prospectus spells out a lot about the aircraft that the bond proceeds will finance: the number and description of the planes, projections of their annual depreciation rate and-most important-loan-to-value ratios obtained from independent appraisals. The ratios are used to subdivide the bonds into the credit tranches. The Class A certificates, for example, have conservative loan-to-value ratios, generally from 40% to 45%, meaning that the amount of debt at this seniority or higher is 45% of the appraised value. The lowest tranche, Class C, will have a loan-to-value ratio between 60% and 70%. That's not too bad, considering that bank automobile loans can start out at 90% or more.

So much for credit quality. The other issue for bondholders is rate risk-especially the risk that bonds will be called in prematurely if that works to the issuer's advantage. The airplane bonds come in several varieties. There are sinking fund versions, in which a percentage of the outstanding amount is retired every year, callable bonds (retired early at the option of the issuer) and noncallable bonds (called "bullets").

I prefer the noncallable intermediate-term maturities. With bullet bonds, you know when you are getting your money back, so they are easier to evaluate. Sinkers and callables may offer higher yields than bullets, but the risk of getting your money back at an inopportune time may not be worth the meager additional yield.

Sinking fund EETCs can be tricky to evaluate; buy these only if they outyield the bullet bonds by 10 to 15 basis points or more. You get a portion of your principal returned according to the sinking fund schedule. You need to figure that into your yield calculations; the fraction of the bonds that can be taken away varies from less than 1% to 15% of the outstanding issue.

If you're really safety-minded, you can buy insured plane bonds. The same is true for them as for other kinds of issues: They pay a lower yield, often 15 to 20 basis points less. For the airline certificates, MBIA and Ambac provide coverage.

A word of caution on buying insured issues though, whether munis or EETCs. Make sure they are covered by different organizations. An all-Ambac or all-MBIA insured bond portfolio defeats the purpose of diversification.

We are in a very difficult credit environment; EETCs are one welcome solution.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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