Managing the Components of Risk

With more volatility likely, what’s the maximum level of risk you are willing to take in next year’s markets?  The answer requires knowledge of the impact changing traffic levels will have on the values of specific equipment types and portfolio credits. Values that will be driven by the economic, financial, and political environment over the next election cycle. A 2020 Roadmap? Maximum returns, minimum risk. With long economic lives, air and rail equipment values, risks, and returns change over time. Investment in transportation equipment requires an evaluation of lessee credit, specific equipment configuration, transaction structures, book and tax accounting treatment, deal economics, and the governing law of the jurisdiction where the equipment operates. 

Equipment values are intertwined with the financial condition of operators, the markets, and your perception of the future. Traffic demand drives all three. Recent interest rate cuts by the Federal Reserve and continuing trade relations discussions have bolstered expectations for continued economic growth. Unemployment is at its lowest level in 50 years and the services sector has continued to expand. Since predictions are always risky, what is important is to understand the components of risk, know what you want more of, what you want to keep, and what you would like to sell.

If you choose to sell you should satisfy two criteria. First, the proceeds from the sale should be greater than the proceeds from continuing to hold, and second, the reported accounting treatment should result in a book gain. If you’re selling, consider effective marginal tax rates, not just for yourself but for all participants. Understanding this concept is important since it directly influences prices at which assets are traded. A detailed transaction analysis will help understand why you are making money (interest rates, equipment values, taxes, the equipment markets, etc.), and ensure you are choosing the right thing to do, e.g. good economics and good accounting. The remaining question, where to reinvest the proceeds? 

When you made your first investment you made judgments about the lessee credit, future equipment values, and tax rate stability. When you reinvest, you make the same judgments. Diversification of lessees, equipment types, maturities, and the ability to use tax benefits allow you to reduce the overall risk of your portfolio investment.  That risk depends on how your lessee credits and equipment (aircraft and railcars) values correlate with one another. A portfolio that contains a lease of a 737 and a lease of railcars creates diversification which reduces risk and which will reduce the amount of capital needed to maintain your investment. The factors that influence the financial health of railroads and railroad shippers are different than the factors that impact the financial health of air carriers. Extending that analysis to companies in the same industry, there are differences in markets served, and equipment types used. The value of diversification depends on how portfolio investments react to changes in macro variables (freight, passenger traffic, interest rates, GDP) and which exposures impact returns the most.  Consider your lessees’ ability to manage through economic up and down cycles. Over the next ten years, equipment prices may rise, fall, and then rise and fall again. Manage maturities so not all will face the same equipment value market. 

Risk management requires developing a set of expected events and related action decisions that incorporate the probabilities of possible outcomes. Maximize the value of your action decisions by industry, credit, and equipment type. Best case, worst case, most likely. Maintain diversification. 

Managing the components of risk requires working with a better investment manager. Call RESIDCO.