IFR Mexico Roundtable 2014: Part 1
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IFR: Optimism is increasing here in Mexico about the potential for reforms to boost the nation and its capital markets. So now is an appropriate time to gather the views of bankers, treasurers and public officials on the future opportunities and challenges.
Energy reform will soon become a reality, opening up a sector that has been closed to foreign investment for 75 years. This is a watershed moment for the country. What do these changes and the broader reform process mean for Mexico and investors’ perceptions of the country?
Alejandro Diaz de Leon, Ministry of Finance: If you look at the common denominators of the recent reform agenda that President Pena Nieto has put forward, you are talking about non-tradables and what it means for input markets.
Energy reform probably is the one that has the biggest potential in terms of attracting investments and fully allowing Mexico – being an energy-rich country – to exploit its key advantages.
You could have argued in favour of energy reform in different instances in recent Mexican history, but the opportunity cost, or the missed opportunity of not doing it, probably is bigger now than ever.
On the one hand, we are running out of easy oil. The great Cantarell oil field and those types of wells are in the decay phase, and marginal oil is more expensive. So more resources are needed. On the other side, new technologies have allowed for a new shale-gas revolution.
The combination of high oil and relatively low natural gas prices offers huge potential for Mexico. You can ensure low cost of energy for your local manufacturing and industrial production, which I think is key, and you also have relatively high oil prices for your export [revenues].
This offers a very positive outlook for the Mexican economy, and this has been recognised by rating agencies and investors.
IFR: Mexico has become the new darling of the investor community, and banks are clearly putting more resources into the country in anticipation of a capital markets boom. What do these reforms mean for new issuance volumes going forward?
Raul Martinez-Ostos, Barclays: I think 2014 has been a turning point for the Mexican international capital markets for many reasons. First of all, you’ve had a surge in issuance beyond the frequent borrowers like United Mexican States, Pemex (UMS) and America Movil.
A number of high-yield names have gone out successfully with historically high order books. This has been helped by the strong technicals – lack of supply from Russia combined with broader liquidity. But there has also been a very specific focus on Mexico and that has led to very successful transactions in the high-yield space.
Investment-grade names, which traditionally were not frequent issuers and relied more on the local markets or bank debt, made the best of those circumstances to look to [the dollar market] with 10 and 30-year transactions.
The high-yield space has been limited to shorter tenors, but the size of those books clearly reflects a strong appetite for Mexico.
It’s very important to say that this virtuous cycle has been helped by performance in the secondary market. If you look at the more than 20 transactions in Mexico year to date, practically all of them are trading above par, or well above par.
The very solid performance of these bonds has generated the appetite to really get into these [credit] stories. Investors are no longer saying they don’t look at deals below US$500m. Now they are doing the credit work because they know that if they do, there is a lot of upside.
During the first half of the year, borrowers have done much of what they needed, but maybe people will start looking for more opportunistic transactions towards the second half of the year.
Beyond the frequent issuers, a lot of borrowers have looked at doing liability management, together with their funding exercises. So they are increasing the average maturity of their debt.
IFR: What about pricing? Has this improved as a result?
Martinez-Ostos, Barclays: A lot of these names in the past had access to the markets but at 200, 300 or 400bp above where they are issuing today.
Juan Claudio Fullaondo, HSBC: Most Mexican companies that can access the high-yield market are companies that also can access the bank market as well. So you see a lot of competition between the banks and the high-yield bond markets. But some borrowers still don’t want to take on the full cost involved in registering their business [for a bond transaction].
IFR: What impact will these reforms have on Pemex’s funding needs and the way the company accesses the market?
Rodolfo Campos, Pemex: There are some aspects of the reforms that could put some upward pressure on our financing needs, and there are other aspects that could reduce that pressure too. We still do not know the final outcome.
Under the new reforms and the ‘Ground Zero’ proposals, we will have to invest in absolutely all of those assets from the very beginning. If we don’t develop them in three years, we can make a case to the authorities and ask for an extension of two additional years, but that is final. That is the deadline for developing all of the opportunities.
So that is going to put some pressure on our financing programmes going forward. But, on the other hand, the energy reform also gives us more flexibility.
In terms of upstream, we can associate with a third party so they will be the ones developing your asset, and that could reduce some financing pressure for upstream.
In terms of downstream, we have a lot more flexibility. We are not going to be forced anymore to invest in all the value chain, so there is a possibility that we will see a reduction in our financial programme, particularly when it comes to investing in downstream activities.
IFR: As the country’s largest telecoms firm, America Movil has also been impacted by reforms encouraging more competition in this sector. What does this mean for the company’s business model and financing strategy going forward?
Ricardo Rivera, America Movil: Clearly the reform has had an impact on how we view the model in Mexico and basically the rules of our operation have changed.
While before growth by itself was just fine, right now there is clearly a constitutional cap on growth in our sector. There is a limitation as to how big you can get and we are looking at alternatives to get below that threshold.
We are probably going to get a substantial amount of resources from asset sales and, to that extent, the first order of the day will be to reduce the liabilities that the holding company has.
So, effectively a big part of our refinancing needs from now until 2016 will probably not be there.
The company’s financial strategy will not change, which is first and foremost maintaining a certain capital structure. This means maintaining certain leverage ratios against the generation of Ebitda, which has a direct impact on our ratings.
Then, we are looking at growth opportunities elsewhere and in the absence of that, shareholder distributions. But it’s one right after the other. To that extent, refinancing needs going forward will be a lot less.
IFR: Could you talk about your strategy to divest assets, and potential buyers?
Rivera, America Movil: We have found ourselves in this position because of the lack of investment among our competitors and the overreach that we’ve done in investment in Mexico.
A potential buyer of our assets is probably a company that has clear experience in managing a telecommunications network, that has financial strength, and that has the commitment to invest in the long-term. That excludes a lot of the local participants and leaves the door open to a lot of
global operators out there. We would like to find one major acquirer of the assets.
All of this needs to be approved by the regulators first, while we maintain conversations with the different potential buyers.
IFR: Infrastructure financing is a huge component of the government’s plan to get the economy on track for sustainable growth. It has announced a close to US$600bn plan to improve the nation’s infrastructure between 2014 and 2018. Will we see a surge in project deals in the capital markets and how will these be structured?
Last year, BBVA, Goldman Sachs, HSBC and Morgan Stanley brought a rare peso-denominated 15-year bond for Red de Carreteras de Occidente (RCO), which was targeted at both foreign and local investors. Leads managed to place it without a guarantee from local development banks or OPIC. Is this a template going forward?
Fullaondo, HSBC: The first infrastructure deal we did – a tollroad deal for RCO – sets a perfect example of what you want to see in the future, not only in tollroads but I think there is a lot of oil and gas projects that can raise money through structured transactions with longer tenors. We are already working on lots of them, and you will see that there is a huge appetite from investors trying to get into those projects.
Octavio Calvo, Santander: We do see a lot of energy projects coming on line. Most of them, or at least half of them, will be denominated in pesos and the other half will have to go to the cross-border market. As a result it is very important to keep developing the Mexican peso market. America Movil and Pemex are key examples of how to do that today.
In Mexico we do have the local pension funds – called AFORES – that will go a long way to creating demand for these instruments, but they won’t have enough assets under management to absorb all the financing for these projects.
So we will need to bring international investors to the local market. One, because of the buying power they bring to the table. But secondly, they will give liquidity to the market. We do issue infrastructure bonds in Mexico, but they are only placed in three or four big hands. And those investors hold onto those assets until maturity and there is no trading.
Today, borrowers can go to the 144A/Reg S peso market and register the security in Mexico, like America Movil does. Ideally we would have issuers sell local instruments called Certificado Bursatiles [to international investors] and bring custodians such as Euroclear and Cedel here to make them eligible for trading.
However, there are some tax issues that have to be fixed. Specifically there is withholding tax on capital gains, but if we could exempt them from that, Euroclear would be willing to settle those bonds.
Today you could always gross up the interest payments as you do when you issue abroad, by the 4.9% formula. But in Mexico the problem is that if a foreigner sells a bond, he has to pay a capital gains tax, so it’s not efficient for him to transact in the local market.
Campos, Pemex: When you say peso, you also mean inflation-linked instruments as well?
Calvo, Santander: Definitely.
Campos, Pemex: That is key as pension funds have a structural need for that kind of asset.
IFR: Do these structures appeal to foreign investors though?
Carlos Albarracin, Milbank: I worked on probably what was the single-largest UDI [inflation-linked] issuance, Comex, and it’s completely illiquid. The problem that you have in the US is that any inflation index instrument gives rise to something called ‘tax and contingent interest payments’.
This is very similar to being considered a PFIC (passive foreign investment company) as an equity issuer. So you are basically being taxed on future earnings today, which could kill the deal for US investors.
IFR: Does this just apply to inflation-linked transactions or more broadly?
Albarracin, Milbank: Well this is specific to any inflation-index instruments, except municipal bonds and other bonds issued with the full faith and credit of the US or US states.
So it’s a very specifically tailored extension for local instruments. But anything else that is inflation indexed hasn’t really taken off in the US market – 144A or SEC registered – because of these specific taxes.
There are some ways around it, but it makes the transaction structuring phase really complex. There are many emerging market debt funds that have buckets for inflation-indexed securities. For example, there is a market for Peruvian currency-denominated [nuevo sol] securities for infrastructure projects that are inflation indexed.
IFR: Could the bank market help absorb some of these infrastructure needs as it has in the past?
Albarracin, Milbank: With the implementation of the Basel III rules, the bank market doesn’t really have any sort of adequate solutions that provide the necessary tenors for these projects.
RCO was an innovative transaction. It’s almost creating a bank loan product for capital market investors. Those are the kinds of things that will set the bar really high.
Fullaondo, HSBC: International investors are huge players and a lot of them will play these types of projects. But there is a lot of work to be done. There are a lot of very interesting projects that will be coming to the market and part of our work will be convincing them, along with rating agencies to create solid structures that we can sell into the market.
Martinez-Ostos, Barclays: The international investor base is critical in this exercise. When we talk about infrastructure, or oil related projects, there are investors who are very sophisticated who understand these structures, who have done them in other jurisdictions. They understand details such as tollroads and traffic that your traditional investor base that buys into Mexico does not.
[The Oro Negro and the Grupo R drillship-related bonds are good examples of how pricing varies depending on which investor base is targeted. In January, Oro Negro priced a US$725m five-year to yield 7.5%, while in September 2013, Grupo R priced a US$950m seven-year to yield 8.5%.]
They were both related to oil, and energy space. They were similar structures to a certain point, but Grupo R was sold to more traditional investors who buy high-yield bonds and Mexico. The other was bought by investors who specialised and understood these assets.
Oro Negro was bought by Norwegian accounts [with knowledge of the offshore oil market], and Asian investors who understand or have some links to where the jack-up rigs were built. The difference between the two investor bases equated to a 100bp price differential.