Pemex and Fallen Angels in Emerging Markets

Earlier this year, Fitch Ratings downgraded Pemex, the Mexican state-owned oil company, to one notch above non-investment grade. Although the company still has a mid-BBB blended rating and remains in investment grade indices, a further downgrade would have a meaningful impact to emerging markets high yield bond investors given its $100 billion in total debt ($66 billion of which is included in U.S. bond benchmarks). However, a downgrade to junk status is not written in stone. Although long plagued by inefficiency and underinvestment, the company is currently trying to execute a turnaround plan that focuses on reducing its massive debt load. In addition, Mexican President Andres Manuel Lopez Obrador’s administration has proposed tax breaks for the company valued at MXN 90 billion over the next several years. Nevertheless, the bond market appears to expect further pain, judging by the loss in value of Pemex bonds over the past year.

Pemex Downgraded But Still Investment Grade: Pemex 6.5 March 2027 Bond Price

Source: Bloomberg. Past performance is no guarantee of future results. For illustrative purposes only.

What could a downgrade to junk mean? A look at the behavior of previous emerging markets “fallen angels,” or bonds of issuers originally rated investment grade and subsequently downgraded to high yield, may provide some insight. The largest emerging markets fallen angels in recent history followed the sovereign downgrades of Brazil in late 2015 and early 2016 and Russia in early 2015.

As a result of the sovereign downgrades, several state-owned and quasi-sovereign entities were also downgraded. In the cases shown below, prices fell and yields rose significantly ahead of the downgrade as investment grade investors sold their holdings, and subsequently recovered. Fallen angel investors therefore acquired these bonds at attractive yields, and further benefitted as prices recovered following the downgrade.

Prices Recovered Following Rating Downgrades

Brazil: BNDES 4 April 2019 Bond Price

Russia: VEB Finance 6.902 July 2020 Bond Price

Source: Bloomberg. Past performance is no guarantee of future results. For illustrative purposes only.

With a market cap of approximately $420 billion, high yield bonds make up a substantial part of the overall emerging markets corporate bond market, but a downgrade of Pemex would clearly have a big impact. In addition there are approximately $70 billion of bonds rated at one-notch above junk status and on watch for further downgrade (this figure does not include Pemex, which is not currently on watch for downgrade).¹ The good news for investors is that historically, high volumes of fallen angels has provided strong returns due to the forced selling that occurs prior to the downgrade. Further, fallen angels tend to be higher quality than the broader high yield universe, providing a cushion in volatile market environments and against default losses.