Derivative Instruments

9 Months Ended

Sep. 30, 2019

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments

The Company was not party to any derivative instruments in 2018.

In the first quarter of 2019, the Company entered into eight fixed pay/receive variable interest rate swaps (the “Swaps”).

Six of the Swaps were entered into by the LLC Borrowers and have reduced notional amounts that mirror the amortization under the six Term Loans entered into by the LLC Borrowers, effectively converting each of the six Term Loans from a variable to a fixed interest rate, ranging from 5.38% to 6.30%. Each of these six Swaps extend for the duration of the corresponding Term Loan, with maturities from 2020 through 2025.

The other two Swaps, the Credit Facility Rate Swaps, were entered into by AeroCentury and have notional amounts that total $50 million and extend through the maturity of the Credit Facility in February of 2023. Under the ISDA agreement for these Swaps, defaults under the Credit Facility give the Swap counterparty the right to terminate the Swaps with any breakage costs being the liability of the Company. The counterparty has agreed under the Forbearance Agreement to refrain from exercising any termination or other remedies as a result of the Company’s defaults under the Credit Facility during the forbearance period under the Forbearance Agreement.

The Company entered into the Swaps in order to reduce its exposure to the risk of increased interest rates. With respect to the six Swaps entered into by the LLC Borrowers, the Swaps were deemed necessary so that the anticipated cash flows of such entities, which arise entirely from the lease rents for the aircraft owned by such entities, would be sufficient to make the required Term Loan principal and interest payments, thereby preventing default so long as the lessees met their lease rent payment obligations. The two Swaps entered into by AeroCentury protect against the exposure to interest rate increases on $50 million of the Company’s Credit Facility debt.

The Company estimates the fair value of derivative instruments using a discounted cash flow technique and uses creditworthiness inputs that corroborate observable market data evaluating the Company’s and counterparties’ risk of non-performance. Valuation of the derivative instruments requires certain assumptions for underlying variables and the use of different assumptions would result in a different valuation. Management believes it has applied assumptions consistently during the period.

The Company has designated seven of the Swaps as cash flow hedges. Changes in the fair value of the hedged swaps are included in other comprehensive income, which amounts are reclassified into earnings in the period in which the transaction being hedged affects earnings (i.e., with future settlements of the Swaps). One of the Swaps is not eligible under its terms for hedge treatment. Changes in fair value of non-hedge derivatives are reflected in earnings in the periods in which they occur.

In October 2019, the Company concluded that the forecasted cash flows intended to be hedged by the Credit Facility Rate Swaps (with a total nominal value of $50 million) are not probable of occurring as a result of the defaults under the Credit Facility. Therefore, those swaps will no longer be subject to hedge accounting and future changes in fair market value will be recognized in earnings as they occur. As discussed in Note 12, to the extent the Company determines that it is not reasonably possible that some or all of the forecasted cash flows (i.e. interest payments) will occur, the amount of accumulated other comprehensive income related to such cash flows will be recognized as an expense at such time, presumably in the fourth quarter of 2019.

The Company has reflected the following amounts in its income and other comprehensive income amounts:

	For the Nine Months Ended September 30,					For the Three Months Ended September 30,
	2019			2018		2019			2018
Change in value of Swaps	$	455,100		$	-	$	3,700		$	-
Other items		7,100			-		28,000			-
Included in interest expense	$	462,200		$	-	$	31,700		$	-
The following amount was included in other comprehensive income, before tax:
Change in value of hedged Swaps	$	(1,979,200	)	$	-	$	(146,500	)	$	-

Approximately $550,200 of the current balance of accumulated other comprehensive income is expected to be reclassified in the next twelve months, although certain additional amounts may be recognized in the event the Company determines that some of the forecasted cash flows that are intended to be hedged under the Credit Facility Rate Swaps related to its Credit Facility are probable of not occurring.

At September 30, 2019, the fair value of the Company’s Swaps was as follows:

Designated interest rate hedges fair value	$	(2,259,400	)
Other interest rate swap		(75,200	)
Total derivative (liability)	$	(2,334,600	)

The Company evaluates the creditworthiness of the counterparties under its hedging agreements. The swap counterparties for the Swaps are large financial institutions in the United States that possess an investment grade credit rating. Based on this rating, the Company believes that the counterparties are creditworthy and that their continuing performance under the hedging agreements is probable.