Description

PEMEX USD long bonds

PEMEX 6.95 01/28/60 @ 68

PEMEX is already trading like the fallen angel that it will soon become, creating a powerful technical as $100b bonds hit the relatively small market for EM high yield debt. PEMEX is trading at a record spread to the sovereign, which in turn is trading at a near record to the US sovereign. Mexico 2050s trade +350 while PEMEX 2060s trade +550 to the sovereign for +900. 

The bonds are BB Neg at Fitch, BBB Neg at S&P, and Baa3 Neg at Moody’s. Moody’s could downgrade PEMEX any day, which would officially throw PEMEX into junk potentially creating a powerful technical. At the risk of being too cute, we think the market is pulling forward the Moody’s downgrade, and the technical is playing out today. 

Mexico vs US 2050

PEMEX 2060 vs Mexico 2050

Admittedly, any analysis of PEMEX is political and speculative, at best. The assets are garbage, the production declines persistent, the cash burn huge, and the mis-management total. 

All that said, we believe that under AMLO, PEMEX is the sovereign and that the government will be forced to act to confirm that over the next 18 months. Doing so will certainly improve the credit quality of PEMEX and may paradoxically improve the credit quality of the sovereign by confirming a commitment to foreign creditors. As a decent USD credit (45% debt/GDP w/o PEMEX, 55% debt/GDP w PEMEX), PEMEX bonds could have tremendous convexity in a ZIRP world, driving an asymmetric expected value. Importantly, the long duration bonds have the best of both worlds: low dollar price (less downside in jump to default) and the most juice in a tightening play. 

Quick facts: Mexico debt/gdp 45%, PEMEX debt/gdp 10% ($100b), PEMEX % government revenues 18%, Mexico USD reserves $186b

There are two big risks. The first is that EM blows up generally and countries can’t roll USD debt. It’s certainly possible, COVID is hitting EM very hard, but there are cheaper ways to hedge this risk like high dollar price, shorter duration Ukrainian or Egypt debt. The second is the idiosyncratic risk that AMLO lets PEMEX default. 

If AMLO were a hedge fund guy, he might realize that the situation is hopeless, try to harvest as much cash as he could, then restructure the debt and blame the Wall Street vultures. He still might do this, and we’ve put quite conservative probabilities in our expected value for this scenario. Importantly, PEMEX has plenty of liquidity for the next 12 months so a zero-coupon jump-to-default seems highly unlikely. 

But AMLO isn’t behaving this way, quite the opposite. He has repeatedly stated a commitment to PEMEX. It’s a pillar of his government policies. It’s a national champion and he’s a nationalist. Failure of PEMEX would be a big black eye. 

Look no further than his actions. The government has repeatedly supported PEMEX with royalty and tax reductions, cash injections, and limited debt guarantee support. The government also support the Mexico City Airport bondholders, an action that surprised many. AMLO appears unwilling to get into a fight that may tarnish his image and impair Mexico’s access to the capital markets. 

As of today, the PEMEX situation is in suboptimal disequilibrium. The government is footing the bill for the company’s cash burn which is exacerbated by a high cost of debt, but not reaping the benefit of the consolidated sovereign rating. The ballooning cost of PEMEX bond issuance will force the government to take action: let the company default and restructure it, or provide more explicit support. 

We think that the best option for AMLO is to just guarantee all of the debt outright, refinance the capital structure over time and lower the cash burn. But the reality is that his actions are more likely to be incremental, and the most probable step is issuing new guaranteed debt on an ad hoc basis as needed to refinance maturing debt. This won’t be the homerun that we hope for, but should be explicit enough to drive material upside and take the bigger downside risks off the table. And, every year is 10% current yield.

Catalyst

Explicit or implicit government support over the next 18 months