Adds graphic, details on possible fleet liquidation
Hertz's Chapter 11 bankruptcy protection filing is bringing attention to risks in this sector of the ABS market.
Last Friday, the car rental company filed after a plunge in used car prices combined with a drop in demand for car rentals amid the Covid-19 pandemic squeezed the ABS structures the firm used to finance its vehicles.
The combination of those two negative trends in a bankruptcy scenario is drawing concerns over the legal and financial protections of a financing structure that has traditionally served both borrowers and investors well.
"It has been a sector we've always been wary of," said John Kerschner, head of US securitized products at Janus Henderson. Rental car ABS do not have "good risk/return metrics even at the AAA level."
Like other car rental companies, Hertz has used asset-backed securities as a cheap line of funding to help finance its fleet of vehicles.
The firm had over US$6bn outstanding ABS, according to Fitch.
The ABS structures offer a less expensive cost of funds than unsecured corporate debt as the offerings are, in theory, bankruptcy remote from the corporate entity - and the residual value of the used cars offers lenders a degree of security.
However, when the value of those used cars drops, lenders to the ABS facility expect the borrower to stump up cash as collateral, which is what ultimately pushed Hertz over the edge.
The widely followed Manheim used vehicle index sank by 9.2% in April year-over-year to its lowest level in three years before rebounding by 5.74% month-over-month in the first half of May from the end of April.
"A sharp and unexpected reduction in used car values precipitated by the coronavirus crisis burdened the Company with a substantial cash payment due April 27, 2020 in connection with its primary U.S. rental fleet financing arrangement," the company said in bankruptcy filings.
"The Company elected not to consume its precious liquidity and did not make that payment."
CLOCK RUNNING
The Chapter 11 filing now starts the clock on what is expected to be a complicated restructuring, as creditors in a capital structure made more complex by the rental ABS financing jockey for position.
"These rental fleet ABS structures all looked great on paper, had very defensive structural merits, used conservative assumed annual depreciation rates, and had a very good history even across the credit crisis and after 9/11," said CreditSights analysts in a note on May 23. "Now the real world test is here."
The risks for Hertz ABS investors will now largely be determined by the courts and company negotiations with holders of the ABS variable funding notes.
Since the Chapter 11 filing, a 60-day period has gone into effect, during which the ABS trustee and collateral agent are precluded from repossessing its some 500,000 fleet vehicles on behalf of the VFN holders.
During the bankruptcy period, cash from the sale of Hertz's vehicles will go to bondholders as an early amortization event, while letters of credit can used to fund interest payments to bondholders if there is a collection shortfall, according to Wells Fargo analysts.
If the courts uphold Hertz's lease, the company must resume making the lease payments. If courts reject the lease the fleet could be liquidated, the analysts said.
"For ABS bondholders, the primary risks in a liquidation scenario are vehicle depreciation, fair market price declines and the amount of time it takes to liquidate the fleet," the Wells analysts wrote in a research note.
In previous rental car ABS issuer bankruptcies, ANC Rental resumed lease payments after the lease was affirmed and the 60-day stay period ended when it filed for bankruptcy in 2001, while Budget Group continued to make its lease payments without interruption when it filed in 2002.
Given the modest rebound in used car prices so far in May, potential losses to senior ABS bondholders are unlikely, the Wells analysts said.
HEAVY TRADING
Hertz ABS bonds were the most heavily traded in the sector last week, according to Bank of America researchers.
Its Triple A bonds, with a current face value of over US$1.2bn, changed hands last week at an average cash price of US$89.75, according to the bank.
On Tuesday, they were quoted about the same level as Hertz's bankruptcy was likely factored into their prices, two market sources said.
"With a Chapter 11, you are more protected as a senior ABS bondholder, but if it were a Chapter 7 filing, you're looking at a forced liquidation. It just becomes messier," a senior portfolio manager said.
Hertz's ABS B notes, which Fitch downgraded to BB- from A earlier this month, were quoted at 80 cents to the dollar, they said.
Concerns about the broader health of rental ABS structures are also showing up in the secondary market.
While spreads for prime auto loan and credit card ABS have now retraced 92% and 96% of the Covid-19 induced spread widening, average rental car ABS has only pulled back 32%, Bank of America said in a report.
Hertz also carries US$2.7bn of unsecured high-yield bonds across its 6.25% 2022, 5.50% 2024, 7.125% 2026 and 6.00% 2028 notes, according to bankruptcy documents.
The 6.00% notes due 2028 dropped by 3.25 points to trade at a cash price of just 9 on Tuesday.
The company said it had US$1bn of cash on hand to support ongoing operations.
The firm said on May 23 that it may seek access to additional cash including new borrowing, as the restructuring progresses, noting that "uncertainty remains as to when revenue will return and when the used-car market will fully re-open for sales, which necessitated today's action."
GRAPHIC: Manheim US used vehicle value indexhttps://tmsnrt.rs/2X4pXDf