Pimco, TCW vector into unexpected sector

Pacific Investment Management Co. LLC and TCW Group Inc. are investing in bonds guaranteed by aircraft as U.S. airlines hold back from adding seats to protect profitability, preserving the value of their planes. Through last Thursday, junk-rated airline bonds, including enhanced equipment trust certificates from Delta Air Lines Inc. and UAL Corp., had returned 1.4% this month, compared with an overall 0.05% gain for high-yield notes, Bank of America Merrill Lynch indexes show. The gap, the widest since May, comes after airline bonds trailed by 0.44 percentage points in July. The bonds are gaining appeal as traffic for the nine biggest U.S. carriers increases. It has risen 1.9% this year through July compared with the first seven months of last year, according to data compiled by Bloomberg. More than 600 planes, many of which are older and less fuel-efficient, have been parked since the start of 2008 to slash capacity during the recession. That makes the remaining aircraft more valuable as collateral on bonds. “I particularly like these bonds because you're very much collateralized and yet the yield is very compelling,” said Mark Kiesel, global head of corporate bond portfolios at Pimco, manager of the world's biggest bond fund. “Because the airline industry has taken capacity out of the system, and because China and the emerging markets are booming, the demand for aircraft has been rising.” Investors are scouring credit markets for opportunities as the slowing economy fuels demand for fixed-income securities, sending yields on investment-grade corporate debt to a record low 3.74% last week. Orders in July for durable goods in the U.S. increased less than forecast, and sales of new homes unexpectedly dropped, increasing the risk of a renewed recession in the world's largest economy.

MEAT ON THE BONE

While airline EETCs have rallied, “there's still some meat on the bone,” said Tad Rivelle, head of fixed-income investment at TCW Group, which has about $115 billion in assets under management. “We do like the asset class quite a bit,” he said. Elsewhere in credit markets, Southern California Edison Co. sold $500 million of bonds at the lowest yield on record for 30-year debt. The extra yield investors demand to own company bonds instead of government debt rose 1 basis point to 178 basis points, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. The 4.5% notes from Southern California Edison yield 4.539%, or 1 percentage point more than similar-maturity Treasuries, Bloomberg data show. The utility owned by Edison International sold the securities at a lower yield than the 4.568% that San Diego Gas & Electric Co. got in a $500 million offering of 30-year debt last Monday.

HEAVY HITTERS

Bonds from Goldman Sachs Group Inc., the most profitable firm in Wall Street history, were the most actively traded U.S. corporate securities by dealers last Wednesday, with 106 transactions of $1 million or more. Ranked second was General Electric Co., the world's biggest maker of jet engines, with 87 trades. Ford Motor Co., with 60 trades, was the most active in junk bonds, which are those rated below Baa3 by Moody's Investors Service or less than BBB by Standard & Poor's. Airlines have issued $4.16 billion of dollar-denominated EETCs since the beginning of 2009, compared with $1.92 trillion of sales in the U.S. corporate bond market. EETC offerings are limited because of the availability of collateral, said William Hochmuth, a senior debt analyst at Thrivent Financial for Lutherans, which oversees about $64.7 billion in assets. The nine largest U.S. airlines filled 82.5% of their available seats this year through July, an increase from 80.3% a year earlier, Bloomberg data show. Renewed interest in EETCs is driven by airlines' capacity discipline, which is leading to profitability and improved balance sheets as demand recovers, said Jeff Straebler, fixed-income strategist at RBS Securities Inc.

'LOOKS GOOD'

“Investors are looking for yield and they see EETCs and say "Hmmm, that looks good,'” he said. “They're taking the time to re-educate themselves on the product.” On June 28, Delta issued $450 million of eight-year, 6.2% notes, the most recent dollar-denominated EETC offering, Bloomberg data show. The debt is backed by 22 Boeing Co. planes delivered from 1999 to 2000 to the carrier and two from March of this year, according to a regulatory filing. The securities, rated Baa2 by Moody's and A- by S&P, have climbed to 113.68 cents on the dollar from par to yield 4.14%, Bloomberg prices show. The overall investment-grade corporate bond market yields 3.79%, Bank of America Merrill Lynch index data show. Gains are led by trans-Pacific travel, where Continental Airlines Inc. posted a 20% gain this year and Delta had a 12% increase.

INDUSTRY THREATS

Threats to the industry include terrorism, accidents, a slump in business travel and costly schedule disruptions such as those triggered this year by East Coast blizzards and a volcanic eruption in Iceland. Airlines are updating their fleets with newer planes that are more fuel-efficient as oil prices average $78.07 a barrel this year compared with $55.34 for the same period in 2009. Oil reached a record $145 a barrel in July 2008, prompting most of the biggest carriers to park jets, slash jobs and cancel unprofitable routes to lower costs. U.S. airlines had the largest capacity reduction since World War II last year. A new Boeing 737-800 from the most commonly flown 737 family of aircraft would cost about $45 million after discounts awarded for a small order are applied, said Fred Klein, president of Aviation Specialists Group Inc., which values planes. The jet would retain about 80% of its value after five years, 70% after 10 years and 40% after 20 years, he said. “Not only is the collateral doing OK, but the airlines in general across the spectrum are liquid, they're making money,” said Roger King, an analyst at CreditSights Inc. who has covered airlines for 20 years. “The whole industry from a creditor standpoint is in very good shape.”