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Fund managers fear an “avalanche” of selling of Pemex bonds if the strategically important Mexican oil company is hit by a second “junk” bond rating.

The state-owned group, which has $80bn of hard-currency bonds outstanding, was downgraded this month to BB+, below investment grade, by Fitch Ratings, which cited its “deteriorating credit profile” amid sharp slides in oil production and reserves.

A second downgrade to junk, or high-yield status, by a major rating agency could lead to a wave of forced selling by investment funds and mandates only permitted to hold investment-grade debt.

With Moody’s currently having Pemex one notch above junk, and with a negative outlook, that could happen at any point.

“If Moody’s tripped over the threshold in six or 12 months, that would cause an avalanche of selling,” said Marton Huebler, assistant portfolio manager at Fidelity International.

“We could see considerable selling,” added Siddharth Dahiya, head of emerging market corporate debt at Aberdeen Standard Investments. “It seems quite likely that Pemex will get downgraded by Moody’s at some point. We just don’t know whether it’s this month or in six months.”

Given the sheer size of Pemex’s debt load, it would be the largest “fallen angel” to tumble into the high-yeld emerging market basket ever, displacing Brazilian counterpart Petrobras, which caused shockwaves when its $50bn bond pile was downgraded to junk status in 2015 amid the sprawling Lava Jato corruption scandal.

“We have seen this movie before and it was called Petrobras, and Pemex is bigger,” said Bryan Carter, head of emerging market debt at BNP Paribas Asset Management. “It will have an enormous displacement effect on portfolios, on the asset class, on benchmarks.

“People say it’s priced in, but we always have forced sellers and it always gets ugly. It’s fairly clear that’s where we are heading with Pemex, so get ready.”

Estimates of likely forced selling swirling around the market range from $10bn to $15bn. Little of this is believed to have occurred as yet, however, despite Pemex’s benchmark 2029 bond yield rising to 7.04 per cent, from 6.51 per cent before the Fitch downgrade, and its five-year credit default swaps jumping to 210 basis points over those of Mexico for the first time since February 2016, when oil prices were languishing at $35 a barrel, shown in the first chart.

“We have started to see some forced selling. I have heard about $1bn has been sold. So we can expect another $10bn of dollar-based investment grade holders who cannot keep it through a second downgrade,” said Daniela Savoia, EM credit analyst at Fisch Asset Management.

Mr Huebler put the likely forced selling from investment-grade only holders lower, at $6bn to $12bn, but still said this would be “extreme” for a single company’s bonds.

“It would be roughly the same order of magnitude of Petrobras in 2015. Petrobras sold off enormously, spreads went to 700-800bp, they doubled or tripled, at the short end of the credit curve at least, so the technical effect of forced sellers being forced to dump their holdings in a few weeks was quite extreme,” said Mr Huebler of an episode that saw Petrobras’ bond yields surge as high as 14.7 per cent.

Ms Savoia feared the market impact could be greater still for Pemex’s $17bn of euro-denominated bonds, given the comparatively small size of the euro-based EM high-yield market.

“We have already seen what it looks like when a big euro issuer becomes a fallen angel. We went through that with Petrobras. It’s the Petrobras issue times 10, or whatever it is,” said Mr Carter.

“There is always a reluctance among investors to sell,” before a second downgrade, particularly on the part of funds and investment mandates that are constrained by a need to maintain a low tracking error with respect to the underlying index, he added.

Most investors now believe it is a question of when Moody’s downgrades Pemex to junk status, rather than if.

Francisco Campos-Ortiz, Latin America economist at PGIM Fixed Income, said the oil company’s credit fundamentals had gradually deteriorated in recent years amid a heavy tax burden; insufficient investment in exploration, production, and refining capacity, which has led to declining output of oil, gas, petrochemicals and fuels; and a “relentless” increase in leverage.

Crude production, 2.3m barrels per day in 2015, is likely to be just 1.6m bpd this year, according to Morgan Stanley, while reserves have tumbled from 22 years of production in 2004 to nine years and investment in exploration and production has crashed from $27bn in 2014 to $11.1bn last year.

“A heavy tax burden means it cannot be free cash flow positive under any oil price scenario that we view as plausible. Pemex’s current financial structure is unsustainable,” the bank said.

In the statement accompanying its downgrade, Fitch said Pemex’s “standalone credit profile” — ie if it did not have the potential support of the Mexican government, its 100 per cent owner — was CCC, deeply into junk territory, as the “very high level of transfers from Pemex to the Mexican government continues to significantly pressure Pemex’s cash flow generation and reinvestment ability”.

The big unknown is what help Andrés Manuel López Obrador, Mexico’s president, who sees Pemex as a key pillar of the economy, is able and willing to provide.

“Even with its deteriorating credit fundamentals, the market has largely given Pemex the benefit of the doubt based on the assumption that its strategic importance to Mexico would force the government to do whatever necessary to fully bail out the company, if needed,” said Mr Campos-Ortiz.

The attempts to shore up Pemex so far, in the form of cash injections and tax relief, are described by Morgan Stanley as “timid” efforts “that failed to please markets”.

“I think Pemex is a priority for the government. It’s something Amlo [Mr López Obrador] has stated regularly and consistently. He sees it as a symbol of the government in many ways,” said Ms Savoia.

“But help is going to come in his own way. So far we haven’t seen a capital increase that I think the market was waiting for. That’s something that the rating agencies would like to see.”

Mr Huebler said he expected tax cuts of $7bn-$8bn to allow Pemex the cash flow to invest, although the path to this was not straightforward.

“The government has to be able to support Pemex in order for it to be able to maintain its critical level of capex, but to do that it will have to increase debt, which Amlo promised never to do, or raise taxes, which he also promised not to do,” he added.

Barring a meaningful cut in taxation, so that Pemex does not have to borrow to meet its fiscal commitments, Morgan Stanley argued “a move toward more explicit guarantees for the Pemex bonds may be required,” even though the government has ruled out such a guarantee at this stage, said Ms Savoia.

Any debt guarantees or meaningful financial support would weaken the federal government’s own finances, however, potentially threatening its own credit rating, which was also downgraded by Fitch earlier this month, to BBB, two notches above junk.

Morgan Stanley estimated that Pemex would ultimately need funding of around $15bn a year at today’s oil price and production levels, approaching 1.5 per cent of Mexico’s GDP.

Some see this as a problematically large commitment. “We have five years of López Obrador’s policies here. My base case is that Mexico loses investment grade by the end of that,” said Mr Carter.

Such sentiment is leading some investors to enter a potentially surprising pair trade — long Pemex bonds, short Mexican sovereign debt.

“We are overweight Pemex versus the Mexican government because we think the government support will be very strong,” said Mr Huebler, who argued that it made sense for the federal government to take on board more of the combined financial burden.

“Mexico is still high BBBs, so a 1-2 notch downgrade wouldn’t hurt them as much as Pemex going from investment grade to high yield,” he said.

PGIM Fixed Income also has a long-term strategy of being overweight Pemex debt, underweight Mexican sovereign paper, in the belief that the yield gap between the two will eventually become compressed “as Mexico and Pemex become more closely linked”.

A number of hedge funds have also entered the same pair trade in the wake of the widening of Pemex’s spread over the sovereign, said Ms Savoia, although Fisch sold its position at the beginning of the year.

David Spegel, founder of Fundamental Intelligence, a consultancy, said the blowout in Pemex’s credit default swaps implied the market was already pricing in a downgrade to B+, “so, at the worst, for Standard & Poor’s, a six-notch downgrade, for Fitch a three-notch downgrade”.

“Ratings are meant to see through cycles and be long term so I would not expect a sudden three to six-notch downgrade by any of them,” Mr Spegel said. “But downgrades are imminently probable, more likely two notches and possibly more in the coming months depending on action taken to shore up Pemex’s balance sheet.”

“It’s very messy,” added Mr Carter. “We are going to have too many sellers relative to buyers at the beginning and it’s going to take some time to get resolved.”