Although Islamic financing in aviation has always been niche, it is an increasingly popular alternative financing option for airlines and lessors. There have been at least 30 Islamic aviation finance deals since the beginning of 2013, according to Airfinance Journal’s Deal Tracker and responses to our Islamic financing survey.

“It has been a slower start to the year compared to last year but the volume of deals is now picking up and the fourth quarter is now looking to be quite busy,” says Mario Jacovides, partner at Allen & Overy, who has worked on several Islamic-compliant transactions.

“A number of new deals, particularly in the Middle East, have now picked up and are expected to close in the coming months. We continue to see ijarah leases but also other Islamic products, including murabaha facilities,” he adds.

The back end of 2016 was particularly busy in the Islamic finance market. In November, Abu Dhabi-based Etihad raised $1.5 billion with its debut sukuk, marking the largest aviation capital markets deal in the Middle East and North Africa region. The deal was initially indicated to have an issue size of $500 million, but the airline decided to upsize the offering after a strong demand for the facility. The transaction was the largest non-sovereign sukuk and the largest sukuk out of Abu Dhabi.

Airlines may opt for sukuks to boost their equity for asset financing. Another notable sukuk deal in aviation finance closed in April 2015, when Emirates raised $913 million. The issuance was guaranteed by UK Export Finance, the export credit agency of the UK government. Proceeds of the issuance were used to fund four new A380 aircraft, which delivered in April, May, June and July 2015. The aircraft are on finance lease and operated by Emirates. The transaction marked the first time a sukuk had been used to prefund an acquisition of aircraft.

Oliver Tebbit, a partner at Watson Farley & Williams based in the firm’s Dubai office, says that some airlines the firm speaks to have been interested in issuing sukuk bonds.

“An increasing amount of liquidity is now being put through Islamic-structured funds and some of that is going into the aviation market,” he tells Airfinance Journal. “Are we seeing significant numbers of Islamic structured financing transactions for the airlines we are currently working for? No, but I do think there’s an appetite.”

Some carriers choose to use Islamic financing more than others.

“100% of Saudia’s financing has to be sharia-compliant,” according to Mylène Scholnick, principal at ICF. “It’s a major source of financing for them and the airport. Whereas in comparison, when you look at Emirates, it’s not at all 100% of their financing, it’s a comparably smaller portion – around 2-3%, but that has grown with their capital market access via their sukuk.”

Ijarah leases are another popular form of Islamic financing. One recent notable deal closed between August 2016 and 31 December 2016, when International Airfinance Corporation (IAFC) completed 50 exclusive operating leases to Saudi Arabian flag carrier Saudia. The deal consisted of 30 new Airbus A320s and 20 new A330-300s with various deliveries starting from the third quarter of 2016. The A320s are on 12-year leases and the A330s on 15-year leases.

The total transaction size was $3.5 billion spread over three years. IAFC claims the transaction to be the largest aircraft leasing transaction in the history of Saudia and the largest aviation deal to be secured via Islamic financing.

Market sources say the lessor is looking to close a similar deal with Saudia later this month, amounting to $700 million financed by six banks: Dubai Islamic Bank, National Commercial Bank, Gulf International Bank, Arab National Bank and two other Saudi banks are the lenders. The leases are sharia-compliant and will be structured as ijarahs.

Trying times for airlines

Although there are a few Islamic deals in the pipeline, one source that is active in the sharia-compliant market says there may be fewer Islamic structures in the short term. Noting the big three Gulf carriers, the source adds that Etihad will not likely return to the bank market much after the insolvencies of two of its equity partners, Alitalia and Air Berlin, this year.

The source adds that Emirates is looking to postpone some of its orders, so although the airline will still be doing deals, the frequency of deals looks likely to decrease.

“Airlines in the region have found the last 12 months difficult,” adds Watson Farley & Williams’ Tebbit. “Load factors are lower and low oil prices don’t really help the airlines over here; it just means that the people who are based locally are travelling a bit less and there’s a certain oversupply of the aircraft from the airlines’ perspective.

“They’ve committed to taking greater numbers of aircraft than they can fill or at least fill to the degree that they need to try and keep profitable. Airlines have been trying to delay some deliveries and that’s obviously going to impact the number of financings that get done as well.”

Local liquidity squeeze

There are also challenges that the Islamic banks face. Some of the European and Asian banks have been quite aggressive on pricing, often leading to more competitive financing being available elsewhere. As well as this, the low oil prices have had an impact on the local banks’ ability to lend and the cost of capital from the banks has also gone up in the market as a whole.

Tebbit also says that Middle Eastern banks have targeted the aviation sector quite aggressively over the past four to five years and are now showing signs that they are starting to hit their lending limits.

“The GCC banks are under more pressure to not do lending at the moment,” he adds. “They’re trying to sit on their reserves a bit more than they have done in the past five years. Over the last 18 months, I’d say that local banks are doing a bit less lending but the levels of the liquidity in Islamic funds is perhaps a little bit higher than it was.”

With the Middle East being under economic and political pressure, airlines have to be more creative with their financing. Although the oil price is not as high as those governments would want it to be, it has been at a steady level at about $50 a barrel for the past four months, giving more support to Islamic financings and the banks’ spending plans going ahead.

Despite these obstacles, an Islamic financier tells Airfinance Journal that the Middle Eastern banks are not shying away from aviation financing.

“We are still willing to look at it. The problem is that, for example, if an airline like Oman Air is coming up with new plans for 787s, they don’t have projections. Emirates is the only airline here which runs on its own; everybody else relies on the government. So, if Oman Air says that it needs financing and the government is not willing to stand behind it, all the bankers will shy away because it’s not making money.”

Instead of looking at whether the issuer is based in a Muslim country, says the source, Islamic banks focus on the creditworthiness of the airline, with a particular emphasis on whether it is sovereign-controlled or controlled privately. A state-controlled airline such as Kuwait Airways is much more likely to be kept afloat by a government if it was to go bust than an airline that is privately owned.

“There was so much demand for the Etihad sukuk,” says the source. “You know why? Because Etihad is backed by Abu Dhabi. There is no hard-and-fast rule that we prefer only Muslim countries. We prefer any airline which is doing well and we are willing to support that.”

Pricing problem

Although there appears to be appetite from the funding side for aviation, a problem for the Islamic banks is that many of the airlines cannot understand the financing structures.

“I’d love to finance Singapore Airlines or Cathay Pacific,” says the Islamic financier. “What is stopping them is that they don’t understand Islamic structure. For them, the convention is so easy. We’ve tried to explain it to them that it is not so difficult.”

Marc Bourgade, chief executive of Stellwagen Finance, a company that has closed four Islamic deals in the past 18 months, says: “I was talking to an Islamic bank and they were looking for new transactions, so I think there is liquidity in the Islamic financing market. I think it’s a question of finding the right deal for them.

“I’m not sure the Islamic banks are the most competitive ones in terms of cost of funds because you have a lot of European and Asian banks that are very competitive.”

ICF’s Scholnick adds: “I think the pricing is a little bit higher but if you compare it to an EETC that is done in the US, then it’s obviously more expensive. But it gives the banks in the Middle East an opportunity to be involved in aircraft financing and it diversifies the airline’s pool of banks they go to.”

Allen & Overy’s Jacovides says that pricing is not always the determining factor when it comes to airlines selecting Islamic financing deals.

“It’s more a question of to what extent certain airlines like to diversify their funding sources, particularly those with large orderbooks who are more prepared to look at the full array of financings available in the market,” he says.

Tebbit adds that Islamic structures often require more management and are typically a little more expensive than conventional structures.

Untapped potential

Tebbit believes that the growth of Islamic funds is a positive sign, despite restrictions in the lending capacity of GCC banks.

“People are trying to look for a return on assets; banks aren’t giving them a return and retail as well as industry investors are being offered opportunities, being offered better returns if they park money in sharia compliant funds. Whether they are used for real estate, for aviation or for shipping, I think there are slightly better returns than the banks in the region are able to offer.”

Jacovides says that the market will open up more as other Islamic banks become more interested in aviation.

“It’s certainly much easier to document these Islamic deals now as the documentation is becoming more streamlined and they now follow a particular path. The market is getting more used to seeing Islamic deals, not just by themselves but also combined with other products. As more of these deals come to the market, more people will become comfortable with them.”

Jacovides adds that he is now seeing some of the traditional aviation finance banks, such as European banks, coinvesting with Islamic banks on these deals. He says that this is either because the traditional banks have country or airline limits that are nearing their capacity, or by combining traditional debt with Islamic structures it offers the airline a more competitive overall package. Although they are innovative, often these structures have a higher leverage than traditional financings.

An Islamic financier agrees that many of the traditional aviation finance banks are reaching their liquidity limits and, in response to this, he is aggressively pitching sukuks to airlines.

“How much 12-year funding can you do continuously?” asks the financier. “All the banks will get full up. It is better to take out the bilateral club deals with the sukuk so that other sets of investors can come in; so that these lines that are being choked for 12 years can be freed.”

He adds: “These airlines have to understand that for the overall cost of 12-year money, I can go buy a sukuk for 10 years and make money that is tradable and liquid.”