Do you have places that hold a special place in your heart? For me, Mexico is such a destination. The country has a rare combination of incredible history, an impressive art and music scene, as well as strong intellectual capital, with some of the brightest executives and policymakers that I have met in my career.
My recent visit to Mexico City reinforced the view that, from an investment perspective, a lot of stars seem to be aligning. This includes a narrowing of the current account deficit on the back of higher commodity prices, orthodox monetary policy and improving corporate balance sheets, boosted by supportive commodity prices and a focus on deleveraging.
Yet, if one looks at the bonds of Pemex, the largest Mexican oil and gas quasi-sovereign credit, its yields are trading close to double digit levels – the highest absolute yield and relative spread over the sovereign since 2002. Is it just market volatility and investors mispricing the risk or are there other factors contributing to one of the biggest dislocation in yields that we have seen in the last 20 years?
In the midst of macro and geopolitical uncertainty investors require clear guidance and higher levels of transparency from emerging markets (EM) corporate and sovereign borrowers. Those companies that are not prepared to provide this are likely to bear the consequences in the form of higher borrowing costs and limited access to funding in the markets. Pemex is an example, yet it is not an exception. Despite high commodity prices, implicit support from the government and a clear directive to focus on deleveraging all translating into a substantial improvement in the company’s profitability, the market has remained cautious on the story, as witnessed by the continuous increase in funding costs. Yet the market pricing does not reflect this improvement. Why?
The answer lies in three letters that are at the top of investors’ agendas – ESG (Environmental, Social & Governance). Lack of disclosure and compliance with some basic ESG principles has led many investors to throw in the towel on the largest quasi-sovereign company in the country. Having analysed the credit for the last 20 years, we felt that it was important to increase our engagement at this juncture by meeting both the company and policymakers to understand the disconnect. While all companies face certain challenges in the context of the ESG framework, our observation is that in the case of Pemex the hurdle is more related to the lack of disclosure, rather than non-compliance with some of the ESG principles. We were encouraged by the management’s willingness to engage, but the proof will ultimately be in the delivery.
The good news is that, as bondholders, we are not alone. In the banking sector, the largest lenders to the company are also putting ESG compliance as the key condition to continue lending. Domestic pension funds are equally concerned by the lack of transparency and are voting with their feet, encouraging the company to engage. For once, the interests of all the creditors are aligned. Desperate times require desperate measures. In the case of Pemex, this is its ESG moment. Often the challenges that we face are not easily solved but, in this case, we feel that there is a lot of low hanging fruit that the company could address relatively easily to regain investors’ trust and support. This includes basic measures such as signing the adherence to the UN Global Compact principles and publishing the annual sustainability report in English, and with a shorter lag.
Experience has shown us that, for investors, the grass is greener where you water it, i.e. they favour those credits where they can see progress on ESG. Indeed, on a primary screening level, as regulatory scrutiny increases around disclosure and demand rises for evidence of outcomes following engagement, the risk is those issuers that fall behind on ESG metrics will find it increasingly difficult to secure a place in portfolios.
Undoubtedly, the potential reward for companies in responding to investor requirements could be a substantial decrease in the cost of funding. Looking at the evolution of the domestic asset base, local pension funds are projecting their assets under management to grow from 20% of GDP to 50% of GDP by 2030, following a change in regulation that increases the allocation of pension distributions by about two percentage points per year. This equates to approximately USD40 billion annually.
There is a lot at stake, not only for companies, but for the country as a whole. Despite the global turmoil, on a relative basis Mexico compares quite favourably to other countries. While the availability of domestic capital is a positive development, being in the right position from a cost perspective is also key. With labour costs in Mexico about half of those in the US and oil prices a quarter of levels in the US, the country could be an attractive investment destination not only for portfolio investors, but also for Foreign Direct Investment (FDI).
That said, despite the positive newsflow on the nearshoring trend, investors remain cautious when committing for FDI to the country. When global majors, such as Apple, look to diversify their production base away from China, they seem to favour Vietnam and India over Mexico. Why? This has to do with the anti-foreign-investors stance adopted by the current president, e.g. not allowing foreign investors to participate in the farm-outs that are sorely needed for the country to grow its oil production. This sentiment has also been evident in the experience of portfolio investors holding defaulted credits in Mexico. Here, restructuring processes have historically generated amongst the lowest recoveries, in single digits, compared to other emerging market countries, where average recovery rates are usually closer to 40 cents on the dollar.
While, in our view, Mexico has the potential to offer compelling return opportunities for both portfolio and direct investors, these investors will first demand delivery on equally important topics such as corporate governance, transparency and environmental risks in order to engage further.
Although this country has a special place in my heart, Mexico should work on making “its own grass greener” in order to earn the same status as an investment destination. With many of the action points relatively easily achievable, we are hopeful that both the policymakers and senior executives will take our advice on board and start sharing evidence of green shoots in its ESG landscape.