Derivative Instruments

9 Months Ended

Sep. 30, 2020

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments

In the first quarter of 2019, the Company entered into eight fixed pay/receive variable interest rate swaps. The Company entered into the interest rate swaps in order to reduce its exposure to the risk of increased interest rates. With respect to the six interest rate 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 Nord Loan principal and interest payments, thereby preventing default so long as the lessees met their lease rent payment obligations. The two interest rate swaps entered into by AeroCentury were intended to protect against the exposure to interest rate increases on $50 million of the Company’s MUFG 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 designated seven of its interest rate swaps as cash flow hedges. Changes in the fair value of the hedged swaps are included in other comprehensive income/(loss), which amounts are reclassified into earnings in the period in which the transaction being hedged affects earnings (i.e., with future settlements of the interest rate swaps). One of the interest rate swaps was not eligible under its terms for hedge treatment and was terminated in 2019 when the associated asset was sold and the related debt was paid off. Changes in fair value of non-hedge derivatives are reflected in earnings in the periods in which they occur.

Six of the interest rate swaps were entered into by the LLC Borrowers and provided for reduced notional amounts that mirror the amortization under the Nord Loans entered into by the LLC Borrowers, effectively converting each of the six Nord Loans from a variable to a fixed interest rate, ranging from 5.38% to 6.30%. Each of these six interest rate swaps extended for the duration of the corresponding Nord Loan. Two of the swaps have maturities in 2020 and three have maturities in 2025. The sixth swap was terminated in the fourth quarter of 2019 in connection with the sale of the related aircraft,

As discussed in Note 4, in March, the Company determined that the future hedged interest payments related to its five remaining Nord Loan interest rate hedges were no longer probable of occurring, and consequently dedesignated all five swaps as hedges. As a result of dedesignation, future changes in market value will be recognized in ordinary income and AOCI will be reclassified to ordinary income as the forecasted transactions occur. Accumulated other comprehensive loss of $114,600 and $284,500 related to the Nord Swaps was recognized as an expense in the third quarter and first nine months of 2020, respectively.

The other two interest rate swaps (the “MUFG Swaps”), related to the Company’s MUFG Credit Facility, were entered into by AeroCentury and had notional amounts totaling $50 million and were to extend through the maturity of the MUFG Credit Facility in February 2023. Under the ISDA agreement for these interest rate swaps, defaults under the MUFG Credit Facility give the swap counterparty the right to terminate the interest rate swaps with any breakage costs being the liability of the Company.

In October 2019, the Company determined that it was no longer probable that forecasted cash flows for its two interest rate swaps with a nominal value of $50 million would occur as scheduled as a result of the Company’s defaults under the MUFG Credit Facility. Therefore, those swaps were no longer subject to hedge accounting and changes in fair market value thereafter were recognized in earnings as they occurred. As a result of the forecasted transaction being not probable to occur, accumulated other comprehensive loss of $34,500 and $1,421,800 related to the MUFG Swaps was recognized as interest expense in the third quarter and first nine months of 2020, respectively. The two swaps related to the MUFG Credit Facility were terminated in March 2020 and the Company incurred a $3.1 million obligation in connection with such termination, payment of which is due no later than the March 31, 2021 maturity of the Drake Indebtedness.

The Company has reflected the following amounts in its net loss:

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2020			2019			2020			2019
Change in value of interest rate swaps	$	1,980,500		$	455,100		$	(10,000	)	$	3,700
Reclassification from other comprehensive income		538,500			5,900			149,100			28,000
Reclassification from other comprehensive income –    forecasted transaction not probable to occur		1,167,700			-			-			-
Included in interest expense	$	3,686,700		$	461,000		$	139,100		$	31,700
The following amount was included in other comprehensive income/(loss), before tax:
Unrealized gain/(loss) on derivative instruments	$	(575,000	)	$	(1,985,100	)	$	-		$	(174,500	)
Reclassification from other comprehensive income		538,500			5,900			149,100			28,000
Reclassification from other comprehensive income –    forecasted transaction not probable to occur		1,167,700			-			-			-
Change in value of interest rate swaps	$	1,131,200		$	(1,979,200	)	$	149,100		$	(146,500	)

Approximately $232,800 of the current balance of accumulated other comprehensive loss is expected to be reclassified in the next twelve months.

At September 30, 2020, the fair value of the Company’s interest rate swaps was $874,700.

The Company evaluates the creditworthiness of the counterparties under its hedging agreements. The swap counterparties for the Company’s interest rate 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.