Many investors have taken the collapse in oil prices and resulting weakness in Pemex bonds (spreads to the sovereign have widened to more than 700bps) as a buy signal. We disagree.
We retain our Hold recommendation on the family of bonds based on our reconciliation of the company’s poor fundamentals on the one hand, with technicals, market psychology and limited other buying opportunities on the other, which may see Pemex bonds deviate from the company’s fundamentals in the near term. We think this motivates a Hold and not a Sell after recent price action.
Pemex is a shadow of its former self
Historically, when the Pemex spread to the sovereign has exceeded c600bps, buyers have come in droves on the basis that such spreads are excessive, pushing the bonds higher. We are likely to see similar behaviour now. As an example, one of the company's most liquid bonds, the US$3.8bn 5.95% bond due 2031 (Baa3/BBB+/BB+), currently trades at cUS$81.647 to yield 8.58% (g-spread 761bps, z-spread 769bps). The bond traded at a high of US$103.18 on 21 February – a huge change.
However, we believe that it is a mistake to look at Pemex in historical terms. Pemex today is an effectively bankrupt company, with negative equity, more than US$100bn in unfunded pension liabilities, extremely high debt cUS$105bn (indeed, it is the most indebted oil company in the world) and poor management. Moreover, it has no chance of significantly increasing its production levels as long as the government remains determined to roll back the previous administration’s massive Energy Reform (which envisaged more farmout auctions and substantial private capital investment).
Premise of sovereign support is flawed
Furthermore, investors tend to buy Pemex under the premise that the government will shore it up with capital injections, both in order for Pemex to meet its liabilities and also to defend its investment-grade rating (Moody's and S&P).
However, with negative GDP growth in 2019, lower fiscal revenues, a still stagnant economy in 2020, low oil prices and the snowballing global chaos that is coronavirus, there is a material risk that the Mexican government will have limited funds to inject into Pemex this year. For example, if oil falls to, say, US$35/barrel for three months, the government would probably need to use the bulk of its rainy day fund to make up for Pemex’s steep losses.
Reiterating our Hold
We believe most investors are ignoring the company's maladies and are acting on a single technical factor – the historical spread behaviour between the company and the sovereign. This factor tends to mean Pemex bonds bounce strongly from lows of 500-600bps. With the spread at 700bps, this technical factor becomes an even stronger influence. We do not see any factors that could explain or justify upside for the bonds other than this technical factor.
We also know that these price movements are often short-lived. In the end, fundamentals will become a more important consideration once again for investors. When a rating downgrade seems inevitable and it is clear that there is more downside than upside, there will be a steep drop in Pemex bond prices. However, high-yield funds will again pick up the pieces with gusto, propping up bond prices to current levels, in our opinion.
For investors with a longer investment horizon (rather than those who trade dynamically in and out of the bonds), we believe our Hold recommendation is the most sensible way to look at Pemex at this point in time. We would resist the itch to buy on spread differentials.