Description

Summary

Sri Lankan Airlines 2024 7% USD bonds, which were issued in 2018, are currently trading at 69-70 and mature on 25 June 2024. There are $175 million of bonds outstanding and they are sovereign guaranteed. Sri Lankan Airlines failed to make the semi-annual coupon payment on December 25, 2022 and the bonds are currently in default.

We think the bonds are an interesting opportunity with a few near term catalysts approaching that may result in par recoveries. These catalysts include (1) impending privatization of Sri Lankan Airlines, (2) the possible tender or buyback or government assumption of the airlines’ debt ahead of the privatization by the Sri Lankan Government which will trigger a change of control (3) recovery of the Sri Lankan economy post-covid and post-crisis or (4) potential resumption of coupon payments on the bonds

Background and Historical Performance

Sri Lankan Airlines (formerly Air Lanka) is Sri Lanka’s national air carrier established in 1979. Sri Lankan Airlines (“SLA”) operates a fleet of 23 Airbus A 320/I and A 330 aircraft (of which 19 are operational) and provides connections to 109 destinations in 56 countries through its global network.  SLA carries around 5 million passengers and 80,000 tonnes of cargo annually. The Government of Sri Lanka currently holds a 99.52% stake in SLA.

Sri Lankan Airlines was partially privatized in 1998 when Emirates Airlines acquired a 43.63% stake for $70 million. As part of the deal, Emirates took over the management of the airline’s operations for a 10-year period and rebranded the carrier as Sri Lankan airlines.

In January 2008, Sri Lanka did not renew Emirates’ management contract of the airline after Emirates refused seats to President Mahida Raja-paksa and 35 officials on an overbooked to Bahrain and revoked the work visa of Peter Hill, the CEO of the airline at the time. Emirates tried to sell its stake in the airline which it valued at $150 million in 2008 but was unable to find another buyer, eventually selling its 43.63% stake back to the Sri Lankan government in 2010 for around $55 million, increasing the government’s ownership back above 99%.

SLA’s business consists of three segments: (1) airline operations which is predominantly FX earning which is projected to generate $1.1 billion of revenues in FY 2023/2024, (2) ground handling as the sole ground handler at Colombo and Mattala airports which is expected to generate $60 million of revenue in FY 2023/2024 and (3) catering which is expected to generate S42 million of revenue in FY 2023/2024.    

During the 10-year strategic partnership with Emirates, Sri Lankan Airlines became profitable but ran large losses once the government took over. SLA’s performance collapsed as a result of COVID-19 and the subsequent rise in energy prices coupled with FX shortages in the country. The Sri Lankan rupee suddenly devalued in March/April 2022 from around 200 LKR/USD to 360 LKR/USD (Current: 312 LKR/USD). Around 80% of SLA’s revenue is hard currency; however the currency devaluation resulted in significant FX losses due to FX denominated liabilities.    

The economic situation has gradually improved and adverse travel advisories were gradually lifted resulting in a rapid recovery in air travel to pre-crisis levels.

SLA has a high debt burden to the tune of $826 million consisting of the bonds ($175 million), debt owed to state owned banks ($352 million), and to the Ceylon Petroleum Corporation ($299 million). On top of this, SLA owes $771 million to lessors and suppliers.

The debt owed to CPC was resolved in 26 June 2023 when the cabinet approved a capital injection of LKR 102.5 billion ($300 million) to clear the outstanding debt. This was probably easy to achieve given it was effectively an infusion of cash to repay another SOE.  

Privatization Process

In September 2022, Sri Lanka reached a preliminary agreement with the IMF for a 48-month extended fund facility for $2.9 billion.

The IMF’s structural adjustment program requires that Sri Lanka (1) restructure its public debt including the Sri Lankan Airlines bonds which are government guaranteed and (2) restructure state owned enterprises so that they are not a drain on public finances.

Sri Lanka’s public debt stack which stands at 89% of GDP and is expected to remain high for the foreseeable future without a comprehensive restructuring is shown below.  Of the $45.8 billion in foreign currency debt, $4.9 billion is guaranteed debt of state owned enterprises of which the Sri Lankan Airlines bonds are a fairly small portion of $175 million.

The government established a state-owned-enterprises restructuring unit to implement key reforms and determine the best restructuring plan to return SOEs to financial viability.

According to the latest timeline provided by Sri Lanka's State-Owned Enterprises Restructuring Unit, the privatization of Sri Lankan Airlines is expected to be completed by June 30, 2024 with bids due by May 2024. The Government of Sri Lanka plans on restructuring and / or removing debts from the balance sheet of the airline prior to privatization. The Ministry of Finance formally engaged the IFC/World Bank on 10 July 2023 as the transaction advisor to the government for the divestment of its shareholding in the airline.  

In order to be a qualified bidder, the consortium must have available investible funds/capital of at least $200 million and the ability to raise financing of at least $100 million.

Around 16 bidders have expressed interest in the airline with Etihad, Emirates and India’s Adani Group submitting RFQs (Request for Qualification). The deadline with submit RFQs is March 5, 2024 with a shortlist to be finalized by March 2024. The process is expected to be completed by June 2024 which coincides with the maturity of the 2024 bonds.

Until the restructuring is completed, the government has indicated that it will support the airline’s operations as a going concern.

Bond Prices and Relevant Clauses

The bonds are currently trading at 69-70 and are yielding 120-130% assuming that they are paid on full at maturity on June 25, 2024.  

There was a failed attempt to restructure the bonds in January 2023 following the missed coupon payment on December 25, 2022. The proposal involved modifying the Trust Deed to: (1) defer interest payments for 12 months, (2) waive events of default for 12 months, (3) rescind bond acceleration with the consent of 50% of holders and (4) reduce the number of days between a meeting and an adjourned meeting of bondholders and the notice period required for an adjourned meeting. In exchange, bondholders would receive a cash consent fee of up to 15bps.  

The key provisions governing the bonds are summarized below. It is worth highlighting the change of control feature which essentially allows bondholders to put the bonds back the Issuer. Also no restructuring can be completed without 75% of bonds outstanding by principal amount which effectively blocks a forced restructuring by the government (if the Issuer or the government buy back bonds they are not deemed to be outstanding and do not have voting rights). By the most recent precedents (eg. repayment of CPC in full), it is unlikely that bondholders would settle for anything less than par recoveries.  

• Guarantee. The bonds are guaranteed by the Government of Sri Lanka on an unsecured and unsubordinated basis.
• Change of Control. There is a change of control (“CoC”) put option whereby upon the occurrence of a CoC, bondholders have the right to require the Company to redeem the bonds at principal plus accrued and unpaid interest.  Within 10 days following a CoC, the Issuer will give notice to bondholders that a CoC event has occurred, with a redemption date no earlier than 30 and no later than 60 days from the date of the notice. “Control” is defined as the acquisition of more than 50% of the voting rights of the issued share capital of the Issuer (Sri Lankan Airlines) or the right to appoint and/or remove all or the majority of members of the Issuer’s Board of Directors or other governing body, whether obtained directly or indirectly by ownership of share capital, the possession of voting rights, contract or otherwise. 
• Purchase by the Issuer. The Issuer, its subsidiaries or the Guarantor (Government of Sri Lanka) may purchase the bonds in the open market; however bonds held on behalf of the Issuer, its subsidiaries or the Guarantor do not entitle the holder to vote and shall not be deemed to be outstanding.  
• Amendments/Modifications. A meeting may be convened by two or more persons representing not less than 10% of the aggregate principal amount outstanding. Required quorum is two or more persons representing not less than 75% or at any adjourned meeting not less than 25% in aggregate principal amount outstanding to (1) modify the maturity, or interest payment dates (2)  reduce/cancel the principal amount or interest, (3) change the payment currency, (4) modify or cancel the Guarantee. Any resolution passed will be binding on all bondholders. For other amendments, the required quorum is two or more persons representing not less than 50% or at any adjourned meeting whatever the principal amount of Bonds represented.
• Governing Law. The governing law is English Law with arbitration in Singapore.
• Listing. The bonds are listed on the SGX-ST – minimum lot size is $200,000.

Catalyst

Completion of the privatization process by June 2024 which will trigger a COC / call on the government guarantee