JOL vs. JOLCO in the Aviation Sector: What Are They and How Do They Differ?

March 28, 2023

2022 saw a gradual return of Japanese operating leases (JOLs) and Japanese operating leases with call options (JOLCOs) in the aviation sector. These products are essentially used to deploy Japanese equity, bringing back more diverse, cost-effective funding options to the sector while giving airlines the ability to fund 100% of their asset costs. With reports of rising interest rates in the United States into 2023, there will likely be a ripple effect on the cost of rising debt. As nontraditional sources of financing, JOLs and JOLCOs could become increasingly attractive to airlines. But what exactly are JOLs and JOLCOs? What is the difference between the two and why would one be chosen over the other?

The ‘CO’ in JOLCO

JOL and JOLCO structures are both Japan-sourced lease transactions that provide 100% financing, but there are important differences. While there are some market drivers to selecting one over the other, such as whether the core motivation is around tax consideration or purely return on investment, it is worth noting that a JOL is only an operating lease, whereas a JOLCO, while technically an operating lease, is similar to a finance lease with an option to purchase the aircraft at a predetermined date and price.

While not compulsory, airlines are generally expected to exercise the call option in a JOLCO given the costs associated with putting the aircraft back to full-life return condition. This is a balancing act as an airline will need to make strategic and economical decisions, including whether the cost of putting the aircraft in redelivery condition outweighs the value of its estimated useful economic life.

Risks and Rewards

JOL and JOLCO products were heavily impacted by COVID-19, as there were instances where JOLCO aircraft were rejected by airlines through bankruptcy proceedings. In addition, some airlines have chosen not to exercise the call options, leaving the Japanese equity investors exposed to residual value risk.

We have also seen airlines seeking to renegotiate the terms of JOLCOs during the pandemic. While JOLCOs can be an attractive form of financing, they are inflexible because it is difficult to amend the terms of a JOLCO during the life of the transaction. Unlike an operating lease, the airline is dealing not with the lessor in a JOL/JOLCO structure but with the Japanese equity investors, which adds a layer of complexity. A significant amount of time will also be required in obtaining consents and waivers from the Japanese equity investors. Furthermore, the tax positions of the Japanese equity investors will also be affected due to such restructuring.

Demand and Residual Value Guarantors

Before COVID-19, most regions of the world were generally trending in an upward economic direction. There is currently a regional split with several economic directions that have different trajectories. Against that backdrop, Japanese investors are returning to a more conservative approach, refocusing on top lessee credit and the most in-demand narrow-body aircraft asset class.

Recent tax reforms in Japan have also dampened investors’ appetites and limited the pool of lenders that can participate in JOL/JOLCOs. Changes to the IFRS 16 have negated some of the benefits of an operating lease structure, while the 2019 tax reforms in respect of the “earnings stripping rules” resulted in increased tax liabilities for Japanese companies with interest expenses subject to the interest deductibility restrictions. Another implication of the interest deductibility restriction is the potential reduction of the pool of non-Japanese lenders that can participate in JOLs/JOLCPs.

As we move toward a post-COVID world, innovative debt structures such as the combination of traditional JOLCOs with sustainability linked financing or with Aircraft Finance Insurance Consortium (AFIC) and Balthazar insurance products will play a bigger role in future aircraft deliveries. A gradual recovery in line with local economic growth and an increase in deliveries from qualified airline credits is expected.

We also expect to see more competitive JOLCO structures in the coming years, such as the reemergence of residual value guarantees (RVGs). This is where the residual value of an aircraft will be at least a specified amount that can provide additional security for the financing parties, minimizing the exposure of the lessor and providing the airline with certainty as to the value of its investment. Essentially, an RVG is a covenant that grants the holder of the RVG the right (not the obligation) to sell an aircraft at a future date (which generally coincides with the call option date) to the residual value guarantor at a predetermined price (Guaranteed Amount). The Guaranteed Amount consists of the balloon debt and capital remuneration.

In this regard, the Japanese equity investors are therefore hedged against any fall in the asset value, i.e. against the materialization of the risk of the airline not exercising the call option. As a caveat, it is critical that the RVG be subject to specific return conditions and maintenance conditions to ensure that the aircraft is maintained in a good condition. That said, an unanswered question remains: If we see an uptick in the RVG market, what will the pricing of these aircraft be?

While there are some drawbacks, the JOL/JOLCO structure remains compelling, perhaps more so than any other structure.