The banking craze in Mexico for state and municipal debt may be dying down, and signs point to a revival in market issuance. The closing on Sept. 23 of a Ps3 billion ($221 million) bond backed by payroll taxes from the state of Chihuahua could usher in more bond deals from sub-sovereigns.

"We think that in the next 12 months we'll see various deals, but they won't be necessarily backed by payroll taxes," said Angel Cespedes, general director of Corporativo en Finanzas, which arranged the Chihuahua deal.

By far the most common asset used by Mexican states and munis is federal participation revenue, which comes from the central government and is determined in part by oil revenues and the economic climate. Sub-sovereigns have also used own-source flows - such as payroll taxes or tolls charged on roads - to back deals.

Prior to Chihuahua the issuance market had been bone dry since August 2010, when an entity of the State of Mexico known as IFREM floated a Ps4 billon deal backed by flows from property registration fees. Asset-backed loans to these entities, however, saw brisk activity over this period. Indeed, short- and long-term bank lending to sub-sovereigns totaled roughly Ps50 billion in 2010.

Gerardo Carrillo, director of public finance at Fitch Ratings, said that reforms now before the Mexican Congress aimed at increasing transparency in sub-sovereign borrowing could slightly skew states and munis toward issuance, since disclosure in capital markets deals was already higher than in bank lending.

What had kept issuers away from market issuance was not only favorable terms from highly liquid banks. Institutional investors have also been biased against sub-sovereign debt because of a few cases of missed debt payments.

"There have been cases that haven't helped the market and that create the perception of political risk," said a Mexican city-based banker familiar with the sector.

Zacatecas is a case in point. Last year, this state missed some payments on short-term debt after a new administration took office. There was no apparent financial pressure. "This mix of short-term debt with changing administrations has highlighted for us the weak governance and management practices that may appear," said Maria del Carmen Martinez, an analyst at Moody's de Mexico.

But long-term asset-backed debt in Mexico has an excellent track record, whether in the form of loans or bonds.

"Generally for the asset-backed loans we rate there have been no problems at all," Martinez said. With only a few exceptions, the financings rated by Moody's are all backed by federal participation revenue. "It was a good test to see how these deals would perform in 2009 [when participation flows fell 11.3% in nominal terms], and all the structures performed well."

Some of the concern about the sub-sovereign sector stems from an increased use of unsecured short-term debt.

"What we have seen in the last two years is that a number of states are relying more on short-term debt, which isn't backed by any kind of revenue," Martinez said. "It's not a general trend, but if this continues there will be some pressure on refinancing risk."

Martinez added that in general it is easier for a state to take on short-term debt because the structured aspect of longer-time asset-backed debt can require congressional approval.

Fitch's Carrillo said that due to the growth of debt among states and municipalities, some banks have recently started incorporating in their contracts requirements related to leverage, operating expenses and current liabilities.

While both Moody's and Fitch have the sector on a negative outlook, its debt load is still very low by global standards, with debt-to-GDP averaging below 3%.

Institutional investors could soon have another reason to increase their exposure to this sector: an enhancement from state-owned Banco Nacional de Obras y Servicios Publicos (Banobras). "We're going to see the first participation revenue-backed, capital-markets deal with an opportune payment guarantee (GPO) provided by Banobras to [the state of] Oaxaca," Cespedes said.

He added that the GPO has already been used only for restructuring the State of Mexico's bank debt, which took place in 2004 and helped the state improve its creditworthiness in the ensuing years.

Cespedes said that as the issuer rating on a state or municipality limits the potential rating on its structured deal - typically to a four-notch uplift - the GPO might help cut the "vicious cycle" faced by those sub-sovereigns whose low ratings make it impossible for them to access institutional investors even through a securitization.

Fitch's Carrillo affirmed that the rating of an issuer has a strong relationship with its structured deals. "When an issuer is rated very low, there is a greater risk it will try to redirect flows into its coffers," he said.

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