Mexico is facing its deepest recession in decades and prominent investors believe it could soon follow state oil company Pemex in seeing its credit rating relegated to “junk” territory as the COVID-19 pandemic rages on.
Losing the investment-grade rating that Latin America’s second-largest economy has held for almost two decades would be a bitter blow for leftist President Andres Manuel Lopez Obrador.
His fiscally conservative approach to finance and debt is guided by memories of Mexico’s humiliating payments crises and bailouts in the 1980s and 1990s.
“Losing the investment grade rating is a real risk and now something investors increasingly think about,” said Luis Gonzali, a portfolio manager at asset manager Franklin Templeton.
“It could be the event that defines the presidency of Lopez Obrador and leads to investors fleeing Mexico fast, and at a large scale.”
Analysts at JP Morgan said Mexico’s big presence in major investment grade bond indices would exacerbate the scale of forced selling if it becomes a “fallen angel,” a company or country whose ratings have been cut to below investment-grade.
All three ratings agencies have already downgraded Mexico this year.
Fitch Ratings has its sovereign bonds at BBB-, with a stable outlook; Moody’s Investors Services has them at Baa1 and S&P Global Ratings at BBB, both with negative outlooks, signaling further downgrades.
Two would have to rate Mexico speculative grade, or junk, for it to become official.
JP Morgan analysts wrote in a research note that an estimated $44.3 billion of Mexican bonds are at risk of forced selling in the event of a cut to junk.
About $4.5 billion of that total is corporate debt, they said, noting that a sovereign downgrade makes it harder for companies to hold an investment grade rating.
Gonzali estimated the junk label could initially push up borrowing costs for the Mexican government by as much as 300 basis points before settling at around 100 basis points higher than now.
Mexico was long a darling of investors as it reduced the role of the state and appointed U.S-trained technocrats attuned to Wall Street’s preferences to reduce the state’s role in the economy.
But its star was fading even before Lopez Obrador’s 2018 election win.
Despite his frugal ways since taking office, policy decisions including cancellations of billions of dollars of infrastructure projects and the renegotiation of energy contracts have further eroded trust.
Concerns are also growing within the finance ministry, where one official said further downgrades were likely with a cut to junk possible as early as next year.
“The outlook for Mexico’s sovereign debt is very negative,” the official said, speaking on condition of anonymity. “The problem is that there’s now a confidence crisis in the politics of the government.”
JP Morgan’s analysts agreed that a downgrade to speculative grade could happen late next year or in early 2022.
They cited low growth and the state’s crowding out of investors in the energy sector among factors undermining Mexico’s coveted investment grade. They also cited slow progress in diversifying the tax base, and a weak response to the coronavirus pandemic.
Investors already rate Mexican sovereign bonds similar to junk, with spreads to U.S. Treasuries climbing.
The spread has moved “into the pricing range of a security on the cusp of downgrade to high yield,” said Andrew Stanners, an investment director at asset manager Aberdeen Standard.
Carlos Serrano, an economist at BBVA, the country’s largest bank, noted the market priced Mexico’s last sovereign bond issue at a level similar to that of junk-rated Paraguay.
Mexico issued $2.5 billion in April at a yield to maturity of 5%, Serrano said, while Paraguay issued $2 billion the same month, and with a similar maturity, at a yield to maturity of 4.95%.
Not all feel a downgrade to junk is inevitable, however.
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“The decision not to be fiscally expansive could pay off if we get a very quick recovery,” said Stanners, referring to the lack of government spending to offset the pandemic’s economic impact.
“It’ll mean that the fiscal position has not been eroded as harshly as other countries and could prevent rating downgrades to high yield.”
Reporting by Stefanie Eschenbacher; Editing by Christian Plumb and Tom Brown