Latin American deal of the year: Mexico’s $2.5 billion debt exchange warrants

Mexico has long been at the forefront of innovation in sovereign liability management, and in 2005 it launched one of its most impressive deals to date, going well beyond a straightforward bond exchange.

Mexico has done such a good job of developing its yield curves in both pesos and dollars that bond exchanges are increasingly useless: anybody can buy one security and sell another, and there’s little point in doing so through the Mexican government rather than straightforwardly in the secondary market. And bond swaps can be harmful in the short term. If Mexico had simply announced a large dollar-for-peso bond exchange, hedge funds would immediately have started to front-run the deal, selling peso-denominated debt and damaging the Mexican domestic yield curve.

But Mexico still has a long-term goal of reducing its external debt and exchanging it for domestic debt, without adversely affecting either the dollar or peso curves.

The country also had a more immediate goal at the end of 2005: to make sure its debt markets sailed smoothly through the presidential election of 2006. Six years ago, the handover to president Vicente Fox went very well – but that was the first presidential election in living memory that didn’t coincide with an economic crisis.

So Gerardo Rodríguez, Mexico’s director of public credit, had an idea. Why not issue warrants, allowing holders of external debt – be they foreign or domestic – to swap that debt into long-dated peso-denominated MBonos after the election?

The idea was brilliant – so brilliant, in fact, that no Wall Street bank had actually showed it to Mexico. No one had ever issued a cross-currency warrant before, and the banks were hesitant to lay their reputation on the line by asserting that such a thing was possible. But when asked, they also weren’t about to say it couldn’t be done.

The deal was structured so that the warrants can be exercised after the presidential election in July, but before the new president-elect takes office: the exercise dates range from September 1 to November 9, with the longest-dated bonds being exchanged first.

Mexico went on a week-long roadshow at home and in Europe and the US to introduce the concept to investors. The country didn’t need to sell the warrants very hard: there’s an enormous gap between Mexico’s peso and dollar curves – in the order of 300 basis points – and the two are naturally trending towards each other. The warrants are an easy way to make the convergence trade, and in fact the long-dated warrants, which were issued at $35 each, are already trading at $60 thanks to exactly such convergence.

But most investors weren’t betting on the price of the warrants so much as betting on the long-term health of the Mexican economy. The long end of Mexico’s domestic yield curve is already dominated by foreigners, and foreign investors jumped at the opportunity to buy an instrument giving them the right, but not the obligation, to increase their holdings of such bonds after the volatility surrounding the election had passed. The deal generated demand for $11.5 billion notional in warrants, more than seven times the announced $1.5 billion minimum size. Most of the investors were in the US, although a large number of Mexican investors bought the short-dated and medium-dated warrants.

In the end there were three tranches: the XW5s allowed holders of bonds maturing up to 2011 to swap into the MBono 2011; the XW10s allowed holders of bonds maturing up to 2016 to swap into the MBono 2014; and the XW20s went all the way out to the 2033s and swapped into the MBono 2024. The strike price for all of the warrants was set at the forward price on the day of issue, which is slightly higher than the spot price.

Three on-the-run dollar bonds were excluded from the deal: the 2008s, 2015s and 2034s. Mexico did not want to do anything that could damage the liquidity of its benchmark dollar yield curve.

But the really clever part of the deal was that it was designed to improve the off-the-run yield curve even as it was taking liquidity out of those bonds. Mexican corporate debt trades off the sovereign curve, which means it is important that off-the-run bonds do not trade at much of a discount to their on-the-run counterparts. So Mexico inserted a cheapest-to-deliver mechanism into the warrants, which added both value and flexibility for investors while helping to support the price of Mexico’s least-liquid bonds.

Mexico has said it is not going to repeat the deal until the present warrants expire, but it might well revisit the structure then. And the idea is definitely applicable to any other countries that are trying to attract foreign investors to their domestic markets. Turkey, for one, is an obvious candidate.