Investment Opportunities in
General Airport Revenue Bonds

August 11, 2010

By Howard J. Cure

Director of Municipal Research

Evercore Wealth Management

Introduction

Although the airline industry has a volatile history, the airport business has remained relatively calm. We see opportunities for investors in selected General Airport Revenue Bonds (GARBs). Issuance of GARBs has increased sharply as interest rates hit historic lows and the Alternative Minimum Tax (AMT) was temporarily suspended on private activity bonds. Airport bonds may also offer yields above those of essential-purpose utility bonds and in fact can be very stable credits.

Fierce competition, contentious labor relations, fuel cost fluctuations, and inefficient route networks exacerbated by excess capacity have meant many upheavals for airlines since deregulation in 1978. Fares declined initially as passenger loads rose, but ever since, airline passenger levels (enplanements) have had wide swings. The reasons range from security travel restrictions after 9/11, medical epidemics like Severe Acute Respiratory Syndrome (SARS) or H1N1 Influenza (Swine Flu), and worldwide economic expansion and retraction. Airports, too, face economic and competitive risks that have put pressure on certain credits. But many airport bonds have not experienced the same volatility. The temporary suspension of the Alternative Minimum Tax on private activity bonds also offers an expanded investor base.

The AMT suspension

Of the $11.9 billion in airport debt issued in 2008, two-thirds were subject to the Alternative Minimum Tax. Investors demand an interest rate premium to compensate for the additional 28% AMT liability on interest earned and the smaller universe of demand. In an attempt to provide market access and jump start the economy, the American Recovery and Reinvestment Act suspended the AMT for two years on issuance of private activity bonds. (Prior AMT debt issued after 2003 could also be refinanced as non-AMT debt.) This suspension affected many municipal bond sectors including airports, student loans, solid waste disposal facilities, and affordable housing bonds.

For airports, new money issuance for construction or improvements of terminals and most other facilities not related to airfield improvements was now exempt from the AMT. Extending the AMT exemption beyond 2010 is currently under discussion in Washington but is not a foregone conclusion. Failure to extend could cause a further rush of airport issuance before year-end. A recent financing from the Metropolitan Washington, DC Airports Authority showed non-AMT and AMT debt priced at differences of 67-75 basis points, depending on maturity. With such potential savings available, airports have significantly increased issuance and shifted from AMT to non-AMT bonds (see table).

Bond Security for General Airport Revenue Bonds

GARBs are secured by a pledge of all revenues from operation and use of an airport's facilities. This pledge is traditionally supported by a lease agreement with the airlines. The airport-airline relationship is similar to that of a landlord-tenant, in which the airline pays the airport for the use of its facilities. Airports also receive revenues from parking, advertising, land rent (e.g., hotels or office buildings), and such concessionaires as auto rental, restaurants, newsstands, and dutyfree shops. In the U.S., most airports are public non-profits run by government entities or government-created authorities, known as Airport or Port Authorities.

Enplanement Declines and Economic Weakness Still Affecting Revenues in Many Markets

Although economic conditions have improved in many areas, some airports are still under negative credit pressure from reduced enplanements and poor business conditions in the regions they serve. Rating agency reports have noted lower enplanement levels throughout the U.S. domestic market since the second half of 2008 as airlines trimmed capacity and reduce service levels. Enplanement declines of 5-10% were common during fiscal year 2009, but certain airports experienced declines of over 10%. Airports in regions where unemployment is higher or personal wealth lower than the national averages are at greater risk of prolonged enplanement declines. Regions dependent upon a particular industry such as automobile manufacturing or discretionary leisure travel may also continue to lag.

Competition Between Airports

The local economy dictates the level of demand when most passengers at an airport are origination and destination (O&D) rather than connecting traffic. Competitive facilities nearby are a concern, especially if they offer better service. Passengers are often quite willing to travel further on the ground for less expensive fares or more frequent air service. An airport with solid local demand is less threatened by the loss of a particular airline, whose routes would likely be covered by another carrier.

Airports with high cost profiles (usually seen in cost per enplanement statistics) that operate relatively close to competing airports are at some risk. Many low-cost carriers like JetBlue, Southwest, and AirTran choose to operate in lower-cost airports that serve a major domestic market. Fort Lauderdale and Oakland airports, for example, have captured traffic from established, larger airports (Miami and San Francisco). These trends can reverse, however, if larger airports can lure low-cost domestic carriers offering similar fares to where many passengers would prefer to fly. Second-tier airports like Fort Lauderdale and Oakland could then experience the enplanement declines.

International Travel

Airports serving a significant international market often fare well because these routes tend to be very lucrative for airlines and, therefore, not as sensitive to cost per enplanement. In these cases, it is important to understand a local market's economic and cultural ties with the foreign countries that its airport serves (e.g., Miami & Latin America and San Francisco & Asia). If these ties are weak, the airport is subject to competition from other airports around the country.

Hubbing

Airports used heavily for connecting traffic depend less on service area economics. Yet substantial transfer traffic is vulnerable because the choice of connecting facility is not made by the passenger, but dictated by the airline and thus related more to a carrier's viability and route decisions. This is of concern because the airline industry is more erratic than the airport industry. Mergers in particular, such as recent discussions between United Airlines and U.S. Airways and between United and Continental Airlines, can leave certain airports vulnerable to steep enplanement declines. As the rating agencies have noted, a completed merger would likely result in elimination of redundant routes and reduced seating capacity. For airports, this translates into fewer enplanements throughout the U.S. domestic market.

Potential credit problems in a merger can be most pronounced at a combined carrier network's many hub airports. This is particularly true for smaller secondary hubs rather than the large "fortress" hubs where an airline has spent significantly establishing its facilities. Consolidating hubs has often been a key strategy in past mergers to save money. This occurred at the St. Louis Airport, which experienced a 44% decline in enplanements by 2005 from its 2002 peak after the American Airline/TWA merger. Other airports most at risk for credit deterioration in a merger include locations where the two carriers have substantial pricing power (due to large market share) or substantial route overlap and seek to reduce costs by consolidating service and reducing capacity.

Airports versus Essential Purpose Revenue Systems Can Present an Investment Opportunity

As shown in the chart, the spread compared to the AAA municipal scale has been consistently greater for airports than for similarly rated water/sewer revenue systems. The difference in spread has ranged from 14 — 41 basis points. This range has tightened since the spring following a general market trend of tightening spreads.

Certain credit characteristics can help investors avoid or substantially mitigate the risks in the airport sector.

Credit Characteristics We Review When Purchasing Airport Bonds

To sum up, volatility in the airline industry does not necessarily translate into credit weakness for airport revenue bonds. In addition to the issues listed above, many state and regional governments recognize the importance of viable airports to the local business community and often work with an airport authority to manage short-term market disruptions. When Pittsburgh International Airport was reeling from the contraction of US Airways, the state of Pennsylvania considered devoting specific state revenues to pay down the airport's debt. As the source of many well-paid skilled and unskilled jobs, airports can often find state and local governments attentive to their needs. With such additional assistance, GARBs can be a stable component of an individual investor's portfolio.

Howard joined Evercore Wealth Management with over 24 years of experience in analyzing taxexempt municipal securities. He can be contacted at cure@evercore.com.

Download: Investment Opportunities in General Airport Revenue Bonds (PDF)

Important Notice: Evercore Wealth Management, LLC ("EWM") is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. EWM prepared this material for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. EWM may make investment decisions for its clients that are different from or inconsistent with the analysis in this report. EWM clients may invest in categories of securities or other instruments not covered in this report. EWM obtained this information from multiple sources believed to be reliable as of the date of publication; EWM, however, makes no representations as to the accuracy or completeness of such third party information. EWM has no obligation to update, modify or amend this information or to otherwise notify a reader thereof in the event that any such information becomes outdated, inaccurate, or incomplete. Specific needs of a client must be reviewed and assessed before determining the proper allocation for a client and must be adjusted to market circumstances. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Any opinions and analysis herein reflect our judgment at this date and are subject to change as there are changes in relevant economic, legal or political circumstances. Upon request, we will furnish a list of all securities recommended to clients during the past year. This material does not purport to be a complete description of our investment services. This material may not be sold or redistributed without the prior written consent of EWM.