Mexico: current opportunities in fixed income

We see abundant opportunities in the fixed income space in Mexico.

The government’s sovereign US dollar and peso bonds have the biggest weights in the respective JPMorgan hard currency and local currency benchmark indices. The country’s corporates are a significant part of the CEMBI benchmark. The Mexican peso is one of the three most liquid emerging market currencies and trades twenty-four hours a day.

Within that opportunity set, there are a couple of broad themes that we think are particularly attractive. First, the spreads on bonds issued by the state-owned oil company Pemex are too wide relative to Mexican sovereign bonds. We believe the government will continue to support Pemex by providing some combination of financing and tax relief, and this implicit guarantee for the company’s bonds could even become explicit if the sovereign takes some of that debt onto its own balance sheet. This support is premised on the strategic and symbolic role that the national energy champion plays in Mexico, and in our opinion it has only been reinforced by the decisive victory for MORENA in the presidential, legislative and gubernatorial elections in June. Notwithstanding the unjustified spread of Pemex bonds over the sovereign, we have serious concerns about the company’s performance on environmental and governance metrics. The publication of an outline of an ESG strategy earlier this year is a small step in the right direction, but we will continue to engage to urge more deep-seated reform.

The second major opportunity arises from the high level of domestic interest rates in Mexico. Inflation has moderated from a peak of 8.7% in late 2022 to 4.7% in April, and market surveys predict it falling back to the central bank’s target of 3% in around a year’s time. Yet Banxico (the central bank) has only cut its policy rate once so far, from 11.25% to 11.00% in March. We therefore see room for further rate cuts in coming months which would bring yields down and take local currency government bond prices higher.

One other compelling macro theme for Mexico is the prospect of increased nearshoring activity as manufacturers relocate operations to shorten their supply chains into the US market and reduce the risk of falling foul of geopolitical tensions between the US and China. Success in addressing infrastructure bottlenecks to capitalise on nearshoring’s potential would be positive for overall growth and sovereign creditworthiness, but there is no obvious direct fixed income play in this space.

On the risk front, we are closely watching the legislative agenda since June’s elections. MORENA dominant performance gives the government the two-thirds majority needed to pass constitutional amendments, as well as a very comfortable majority for ordinary laws. This sizable political capital should help the new president, Claudia Sheinbaum, to introduce a more sustainable financial solution to Pemex’s debt challenges, which explains that company’s bonds’ relative outperformance. But the more pernicious effect of that super-majority could be that MORENA’s ambitions for structural reform might be realised, including measures that undermine checks and balances on the executive in the form of the electoral authorities, the supreme court and independent regulatory agencies. In addition, MORENA’s stated goals include measures to enshrine rising welfare payments and other public spending in the constitution. While recognising that government action to address inequality and poverty is necessary, we worry that introducing additional rigidity to the budget could lead to rising deficits and additional indebtedness if not accompanied by corresponding upward pressure on revenues.