I. Risk-free issuers
Claudia Álvarez-Toca and Julio A. Santaella-Castell
In only a few years, the Mexican debt market has experienced an outstanding growth, extending the yield curve from one year in 1999 to 30 years in less than a decade. This extension was due to the rapid growth of more domestic and foreign participants, with various investment horizons and strategies. The purpose of this chapter is to offer an overview of the government bond market and its development. The first part of this chapter covers the benefits of developing government bonds denominated in domestic currency, while the second one refers to the pre-requisites to achieve this possibility successfully in any country. The strategy followed by Mexico for this purpose is described next. A final section includes the results of this strategy.
The benefits offered by financial intermediation in general, and of the securities market in particular, are well known. The debt market is the main vehicle through which economic resources are channeled between economic participants with a surplus of loanable funds and those having a deficit. This market also works as a complement for lending and savings through banks, the second major vehicle of financial intermediation.
In 1999, Alan Greenspan (then Chairman of the United States Federal Reserve Board) referred metaphorically to this issue when he stated that the cause of the East Asian markets crisis at that time was that they lacked a “spare tire”. This statement is useful in explaining that those economies depended exclusively on banks for financing and had no alternative for intermediation such as a debt market in their countries.
How is a government securities market developed? Karacadag, Sundararajan, and Elliott (2003) symbolically represented in a pyramid the hierarchical order domestic financial markets follow to achieve their development (Figure 1.1). They recognized the interdependence existing among each market and identified the markets located at the base as fundamental to achieve the development of those at the top. According to this hierarchy, the government securities market is located on the second and third levels (government and treasury bonds).
Hierarchical order of domestic financial markets
|Source: Karacadag, Sundararajan, and Elliott (2003).|
In any of these markets, issuers in need of financing converge with investors that are seeking to put their resources to work in an instrument bearing a yield. The contact between issuers and investors is facilitated by intermediaries. For this to occur, an infrastructure is needed that facilitates the settlement of transactions, which is used in the price formation process, that guarantees the legal ownership of instruments. Finally, the regulatory regime completes the regulatory framework of these financial operations. Under this scheme, the degree of efficiency in the intermediation process will determine, to a great extent, the degree of development of the market.
According to World Bank experts, “an efficient government securities market is characterized by a competitive market structure, low transaction costs, low levels of fragmentation, a safe and robust infrastructure, and a high level of heterogeneity among participants.” To the extent that the debt market is fully developed, it will offer a wider range of financial alternatives for both the government and the private sector. This range of alternatives will generally represent a lower financial cost for issuers as compared to that in a less developed government securities market. Likewise, a more developed securities market will provide to investors access to a broader range of possibilities to place their resources based in their own investment profiles.
Typically, government securities (denominated in local currency) are considered as “risk-free” instruments for private investors, since they are backed by both the confidence and credit of the country’s government, i.e., the sovereign issuer is considered to have enough tax collection and, consequently, payment capacity for its obligations to be completely safe for the investor or debt holder, at least in theory. Usually, the opportunity for issuing debt instruments arises when government bonds are issued and, for this reason, the latter are considered as the center or origin of the fixed-income securities markets available in a country. The government yield curve is the basis for creating the reference interest rate curve for other debt issues. Government bonds also serve as underlying assets for various types of derivatives.
In line with the aforementioned, authorities seek to boost the development of an efficient government bond market in their own countries which, as Greenspan said, serves as a “spare tire” for financing. From a macroeconomic perspective, a government debt market also allows financing budget deficits, helps to reduce government dependence on bank and foreign financing, and strengthens the monetary policy transmission channels. From a microeconomic perspective, it fosters financial stability and improves the channeling of financing funds, as it involves higher competition in the intermediation and development of related infrastructure, products and services. This supports the development of the financial system in general from a system centered on bank financing to a multi-level system in which debt and capital markets complement financial intermediation.
Among other organizations, the World Bank and the International Monetary Fund have set out the different elements that favor the development of debt markets. From these recommendations it may be concluded that the development of the government debt market is a dynamic process where continuity and perseverance in macroeconomic and financial stability are essential to build and keep the government’s credibility as a debt issuer. Besides having a credible and stable government as an issuer, the debt market must also be backed by sound fiscal and monetary policies, an adequate legal, tax and regulatory framework, a safe and efficient security settlement system, and an open financial system with competitive intermediaries. To facilitate competition, actions must be taken to strengthen the disclosure of information, the surveillance and regulation of market participants, and to prevent abusive practices and any other action that threatens free competition.
Domestic and foreign investors are reluctant to purchase government debt instruments, particularly those at mid and long terms, if there is a considerable credit risk, a restrictive regulatory framework, a complex and barely transparent fiscal regime, high inflation expectations or considerable volatility in exchange rates. Preventing all the previous factors must go hand in hand with designing attractive instruments for an investor base with long term investment horizons (the so-called buy-and-hold investors). In this way, the government can solve its long-term financing requirements.
In general, an investor would rather not purchase instruments of a government which is perceived to have a high risk of default. This scenario arises when a government is referred to as either lacking the ability to manage public expenditures and/or collecting taxes, or having a high level of debt (explicit or implicit) that puts its payment capacity at stake. Moreover, a simple and transparent fiscal regime, both for the management of interest payments and capital gains for debt holders will help to attract potential investors.
The fact that inflation expectations are directly reflected in the nominal yield of government instruments limits governments from issuing debt not hedged against inflation, particularly when inflation expectations are considerably high particularly at medium and long terms. When this happens, governments are forced to issue exclusively short-term instruments at floating or indexed-to-inflation rates. Additionally, the foreign exchange regime and restrictions to capital flows (which frame the capital account policy) also have an effect on the degree of development of debt markets in terms of their ability to attract foreign institutional investors with structural investment needs. Finally, an important requirement is to have healthy financial intermediaries that can provide liquidity and efficiency to the debt market.
A sufficiently liquid and developed money market, as the repo market, is another factor that favors the development of long term instruments issued by the government. A sound money market feedbacks the bond market by increasing its liquidity. In other words, it simplifies the process of covering short-term liquidity needs for financial institutions and therefore makes less risky and expensive to keep government securities.
The development of domestic debt markets is particularly relevant for a central bank “as they enable the use of short term interest rates to convey monetary policy signals across the whole maturity spectrum”. This means that the debt market is an integral part of the monetary policy transmission channels. On the other hand, the way in which the central bank implements monetary policy has a significant influence on the structure and development of government debt markets. For instance, the central bank may help foster the money market through its open market operations or prevent the fragmentation of a not-so-developed government debt market by placing the same instruments issued by the government for its monetary operations.
Central bank autonomy and coordination with the fiscal authority
Having an independent central bank that provides a credible nominal anchor (such as an inflation target) is fundamental for the development of debt markets. To achieve this, monetary policy must first be formulated with a sufficient level of consistency. Second, a high level of coordination must prevail between the fiscal and monetary authorities, despite the fact that both have different economic policy objectives. While the practically universal goal of the central bank is to maintain price stability and a sound financing system, the goal of the government is to minimize the cost of its long-term financing, taking into account the risk associated with cash flow management.
Nonetheless, both authorities –as well as the debt market– will be interested in attaining their respective goals, because a monetary policy that it is not credible would affect the perception of investors regarding inflation and the risk of devaluation and, therefore, the cost of government financing. Moreover, the monetary authority would not be able, in the long term, to curb inflationary expectations if the government faces a fiscal or funding problem of such magnitude as to represent risk of monetization and having the central bank financing the government.
As discussed in the previous section, in the finance theory of investment portfolios, a risk-free rate is the yield rate of an investment that has no risk of loss originated by default in payment. In the case of Mexico, risk-free issuers include, besides the Federal Government, the Bank Savings Protection Institute (Instituto para la Protección al Ahorro Bancario, IPAB) and Banco de México (the central bank, also known as Banxico). Their debt issues represent the broad-government securities market.
As for the Federal Government, the Ministry of Finance (Secretaría de Hacienda y Crédito Público, SHCP) is fully responsible for managing the federal debt, with Banco de México acting as its financial agent or broker. The Ministry also coordinates the activities with other bodies of the federal public sector to determine their overall debt strategy, including the type of debt instruments placed, their maturities, and issue amounts and timing of placements, etc.
The IPAB was created and began operations in 1999. The institute is responsible for managing the debt resulting from the bank bailout originated by the 1994-1995 crisis. Before the creation of IPAB, the Federal Government supplied an implicit guarantee for bank liabilities. However, when the cost of rescuing the bank sector became explicit, IPAB practically assumed the total cost of this resolution.
Besides serving as the financial broker for the Federal Government, Banco de México (the central bank), is also a major participant in the debt market denominated in domestic currency. Traditionally, the central bank uses the instruments issued by the Federal Government to add/withdraw liquidity from the money market through its open market operations. However, between 2000 and 2006, Banco de México issued its own monetary regulation bonds (known as BREMs) for the purpose of regulating liquidity in the money market and facilitating the conduct of monetary policy. These bonds where replaced by bondes D issued by the Federal Government in August 2006.
Chart 1.1 shows the composition of broad-government bonds placed in the market, according to its issuer for the period 2001 to March 2014. It is evident that the Federal Government is the main issuer of risk-free instruments in domestic currency. As for Banco de México, the graph shows both the bonds issued on its behalf (BREMs), and the government instruments placed by the central bank for monetary regulation purposes, i.e., to withdraw liquidity on a long term basis and to finance the central bank assets (cetes and bondes D, both for monetary regulation).
The origin of the government bond market in Mexico dates back to 1978, when the Federal Government issued cetes for the first time. At the beginning, the number and amount of transactions was small, the term was very short, there was no secondary market, and the government used a considerable control to determine the yield in primary auctions –for example, allocating a smaller quantity of instruments than that announced at the auction. The first issue of 1-year cetes took place in 1990; however, at times when financial markets became distressed, the government was capable of placing only 7-day cetes.
As for the secondary market, as Sidaoui (2002) explained, it began developing in 1982, when the government allowed banks and brokerage firms to present bids in the public auctions of cetes. During this period, Banco de México gradually began to conduct monetary policy by withdrawing or injecting liquidity through the sale or purchase, respectively, of government bonds. Currently, pension and mutual funds, as well as insurance companies, may also participate in primary auctions for government securities.
As discussed previously, macroeconomic instability hinders the development of financial markets. Periods of high inflation, exchange rate devaluations (linked to balance of payments’ crises), and significantly high levels of external debt were factors that hampered the development of the debt market in Mexico. Chart 1.2 shows how, during most of Mexico’s recent history, inflation and interest rates where at levels above one-digit values. In turn, Chart 1.3 demonstrates how the exchange rate value of the Mexican peso vs. the U.S. dollar practically rose by four in a period of 20 years.
The other aspect of macroeconomic stability that had to be considered to allow a healthy development of the debt market was the fiscal front. Fiscal policy probably constitutes the foundations for building this market. Consequently, all along the 1980s and 1990s, the Federal Government embarked on a major adjustment of public finances in order to maintain the budgetary balance (Chart 1.4).
|1/ The (+) sign means deficit and the (-) sign means surplus.|
As public finances improved, public sector borrowing requirements decreased which, in turn, allowed stabilizing the public debt balance first, and then reducing it as a percentage of GDP (Chart 1.5).
|1/ In December 2008, the Federal Government absorbed the fiscal cost of the Reform to the ISSSTE Law, which amounted to 270.5 billion pesos. As a result, in that month, the public sector debt shows a hike as compared to the level registered during the previous months.
2/ The Federal Budget Law of November 13, 2008 modified the Pemex Pidiregas investment scheme. As a result, in January 2009 Pidiregas liabilities were reclassified from Pemex non-budgetary debt to budgetary debt for a total of 898.6 billion pesos. This change is illustrated in the chart as a hike in the Public Sector's Net Debt since 2009. However, the figure that represents the amount resulting from the "Public Sector Debt" plus the item "any additional liabilities" does not change because the latter item decreases in the same proportion as the Public Sector Debt increases as a result of liabilities from Pemex Pidiregas being registered in the past under the item "any additional liabilities".
Despite the progress in the pursuit of macroeconomic stability, during 1994-1995 Mexico underwent a severe twin crisis of its balance of payments and its banking system. This crisis evidenced the problems of being extremely dependent on external financing (the so-called “original sin” represented in Chart 1.5 due to the considerable share of external debt in the total debt) on the one hand, and having a maturity pattern extremely concentrated on short term instruments. Also, having financial intermediation in Mexico being almost exclusively undertaken through banks, it certainly worked against the national economy.
After this crisis, the need to carry out a thorough transformation of the debt market became evident, particularly for the Federal Government. The strategy the government adopted, as of this time, consisted in decidedly attacking a series of factors that were limiting the growth of its debt market, focusing mainly, according to Jeanneau and Pérez-Verdía (2005), on improving the conditions of demand for government debt and reforming the conditions of institutional investment, among others.
The first condition was to consolidate the process of macroeconomic stabilization, which was supported by the fiscal and monetary policies adopted since the 1980s. It was essential to put public finances in a path of clear and perceptible sustainability after the fiscal cost of the bank rescue. A series of fiscal adjustment actions and reforms were undertaken. The public sector deficit was decidedly reduced (previous Chart 1.4). The aforementioned strategy included considering both the total amount of public debt issued, and the exchange rate risk implicit in its denomination. The consolidation of fiscal discipline has been a fundamental pillar for the development of the public debt market.
In terms of monetary policy, macroeconomic stabilization involved the adoption of an inflation targeting framework in 2002, with all its attributes in terms of accountability and communication. This strategy, based on the appropriate stance of monetary and fiscal policies, represented the possibility of reducing inflation significantly until a low and stable rate was achieved.
The adoption of a free-floating exchange rate at the end of 1994 was also a fundamental element for the change in macroeconomic policy. The Mexican exchange rate history had been based on fixed-type exchange rate scheme with adaptations; therefore, the new regime represented a radical change that allowed, for the first time, to show the benefits of having a free exchange rate market, in which the limited interventions by the Foreign Exchange Commission through the central bank are done on the basis of clear rules. Within this context, since 1994 the exchange rate has evolved according to market forces, including a sharp adjustment during the international financial crisis of 2008.
Since 2000, the government began to implement a clear strategy to manage the public debt focused on favoring the development of the debt market and reducing the Federal Government’s financial weaknesses. Among some of the elements of this strategy that have been implemented are the following:
Improving the predictability and transparency of primary issuance. This is undoubtedly one of the most important elements of the strategy and is aimed at providing certainty to the market by accepting market conditions at the moment of allocating funds. One of the main steps towards predictability and transparency was taken in 2002 when the Federal Government openly gave away its right to determine the allocated interest rates in the primary auctions for its bonds. Additionally, since 2004, the government publishes an annual financing plan as a supplement to its quarterly announcements where both the intended amounts to place by type of instrument, as well as the specific auction calendar for the period are defined.
Reducing the rollover risk by gradually increasing the maturity profile of government bonds. Bonds with longer terms were therefore gradually placed: fixed-rate bonds with 3 to 5 year maturities were issued in 2000; the first 10-year bond was issued in 2001, the 7-year bond in 2002 and the 20-year bond in 2003; finally, the 30-year bond was issued for the first time in 2006.
Reducing the interest rate risk for public finances. This involved trying to concentrate the greater possible quantity of fixed-rate bond issues instead of placing instruments with floating or adjustable rates (indexed to inflation, for instance). Once the adequate mix of maturities was achieved, the goal now is to have a sufficiently diversified portfolio that simultaneously covers the Federal Government’s financing needs and the demand of the different investor niches.
Creating benchmarks. In a yield curve there is a wide set of securities issued at different maturities. Among the measures adopted to foster the government securities market is selecting only certain issues that will serve as benchmarks. This is done by increasing the outstanding amount in circulation through a re-opening process for the purpose of building a critical outstanding amount. In fact, the first evidence of a re-opening dates back to June 1996. However, it was not until 2000 when re-openings began to operate as a usual component of the public debt management strategy by having international financial institutions include benchmarks issues in debt indexes that are now replicated by many investors worldwide.
Introducing a market makers scheme. Another critical element for the development of the government bond market in Mexico, designed to increase its liquidity, depth and healthy development, was the introduction of the market maker scheme in 2000. Market makers enjoy the option of purchasing from Banco de México government bonds at the last primary auction price and of borrowing any instrument of the government portfolio.
Issuing a zero-coupon bond yield curve. In order to meet the investment needs of a certain type of institutional investors interested in longer term bonds that only pay interest at maturity, Mexican financial authorities issued zero-coupon bonds by stripping certain bonos and udibonos issues in which the payment of the principal is stripped from that of coupons. The first instruments were stripped in 2005, and later, in November 2012, the first auction for the placement of the 30-year Udibono stripped principal and interest was carried out.
Introducing the swapping of instruments. As part of this strategy, and to prevent maturity dates of instruments with significant amounts outstanding to concentrate on certain dates, the government adopted a strategy of swapping instruments as of October 2005. This strategy has allowed extending the average maturity date of government bonds and having a better cash management. Nevertheless, swapping has been used in certain cases merely to reinforce benchmark issues and to redistribute bond maturities in a more homogenous manner throughout the yield curve.
Introducing structured debt instruments (warrants). As described by Sidaoui (2009), the increasing presence of foreign investors encourages innovation in debt instruments such as warrants, i.e. structured instruments that offer the option of swapping instruments. With these warrants, investors had the alternative, but not the obligation, to exchange Federal Government UMS (United Mexican States) sovereign bonds –denominated in foreign currency– for government fixed-rate bonds –in domestic currency– at a predetermined price and within the term specified in the warrant’s issue.
Buying government securities in the secondary market. For the purpose of relieving the financial crisis and to maintain order in the public debt market, the Federal Government bought from April to December 2008 some of its instruments in the secondary market, at market prices, through transparent and clear programs. In fact, these purchases were announced in advance and included fixed-rate bonos and both medium and long-term udibonos.
Placing government securities through syndicated auctions. Finally, as of February 2010, syndicated auctions for some issues of bonos and udibonos have taken place. In these auctions, government bonds may be sold to a group or syndicate of financial institutions that buy a specific volume of bonds at market prices for a fee. In this way, a broader investor base is reached, as compared to a traditional primary auction.
All the previous measures correspond mainly to the Federal Government in its role as an issuer or supplier of bonds. The other relevant arm for market development refers to fostering the demand for debt instruments. In this regard, the implementation of certain structural reforms also helped to set sound bases to support the growth of the demand for government instruments. For example, eliminating restrictions to capital flows mobility in 1988, and the previously discussed adoption of a free-floating exchange regime in 1994, fostered the participation of foreign investors in the local debt market. Similarly, the pension reform of 1997, which modified the pension system from one based on defined benefits, to another based on defined contributions, worked as a fulcrum for debt market development. During the reform, private pension fund managers (Afores, for its acronym in Spanish) were created. Later, in 2008, with the reform to the ISSSTE Law, which had a similar purpose in terms of public sector pensions, an additional boost was given to retirement savings. These reforms to the pension system have helped to create a local institutional investor base and a natural supply of long-term funds to finance the government through the securities market.
Together with the previously described measures, a series of reforms to the financial system have also been adopted, some of which have favored indirectly the development of financial markets in general, and the debt market in particular. For example, within this new regulatory framework, the Bankruptcy Law approved in 2000 had an indirect positive impact on government bonds. Indeed, since most repurchase agreement (repo) operations are carried out using government bonds, the new provisions of the Bankruptcy Law provided legal certainty to this market by allowing repo bondholders (or buyers) to conclude their operations in advance by settling rights and obligations if a counterpart goes into default. Before the law was implemented, it was necessary to face obligations first and then receive the corresponding proceedings according to the amount obtained in the bankruptcy settlement. In addition other prevailing laws were amended in 2003, when Congress approved the exclusion of repurchase agreements in the deposit insurance of IPAB, which also reduced the transaction cost of repos. Another example is the Securities Market Law in 2005, which was aimed, among other things, to relax the regulatory framework applicable to brokerage firms and various financial bodies participating in the market (brokerage firms, security deposit institutions, central counterparties, brokers, price vendors and other security rating agencies, among others). The fiscal regime was also considerably simplified to ease the development of the government bond market. In fact, foreign investors are not currently subject to tax withholding for accrued interest by their government bond holdings.
From a regulatory perspective, some changes have supported the development of the government bond market. One of the most relevant was authorizing commercial and development banks, in 1990, to trade instruments in the secondary market with no intermediation whatsoever from brokerage houses. In addition, the regulation regarding the limits for pension funds in terms of investing resources at different terms and types of instruments has also become more flexible.
As discussed before, the characteristics of the systems and mechanisms used to set up and settle transactions are another basic element for the development of debt markets. The growth of brokers that offer efficient trading systems has been relevant for price discovery. Similarly, and in order to standardize and provide more precision to portfolio valuation, price vendors were introduced in Mexico. Price vendors should calculate updated valuation prices for the most important instruments and, since they must value instrument at market prices for most portfolios of financial intermediaries, they play a key role in the securities market.
The central bank, who is responsible in Mexico for the functioning of the payment systems, has made efforts to operate according to international standards and better practices over the last few years. Among the changes enforced is the implementation of the Delivery Versus Payments (DVP) system, which guarantees that instruments are delivered only when the cash covering their purchase is received in return (and vice versa), a fundamental element to reduce settlement risk. In addition, international companies providing services of settlement of securities transactions and custody, such as Euroclear and Clearstream, have agreements with the local banks to settle with them operations with government bonds denominated in pesos (including cetes, bondes D, udibonos, bonos, and shares). Also, to ease the DVP process, Banco de México issued regulations that now allow securities lending. In fact, as stated before, the central bank, as the financial agent of the Federal Government, offers a securities lending window for market makers.
Summing up, Mexican authorities adopted a government bond market promotion strategy as the backbone for the financial and economic development of the country. This strategy addressed a broad range of measures covering different market settings: demand, supply, legal and technical infrastructure, transparency, risk control, among others.
The results achieved to date by Mexico in the development of its government debt market helped to break certain paradigms in financial theory, such as the “original sin” previously mentioned, which considered that developing countries were unable to issue debt in their currency. As can be confirmed in previous Chart 1.5, the Federal Government has been able to replace its external financing with domestic debt, receiving now more resources from the domestic than from the external market. Besides, a yield curve has also been developed in the process. It is remarkable that in only seven years (1999-2006), the government bond yield curve has extended up to a term of 30 years for bonos and udibonos (Chart 1.6). This yield curve has served as a reference for placing debt in pesos to many national, and even foreign, issuers, as mentioned by Sidaoui (2009), and by Sidaoui, Santaella and Pérez (2012).
The combination of stability and financial reforms had a positive impact in financial savings, which, doubled as a percentage of GDP in a period of fifteen years (Chart 1.7). In fact, pension funds (Siefores) started to play a central role in the expansion of saving (Chart 1.8), becoming the most important sector of institutional investment in the country. Indeed, as stated in Banco de México’s Financial System Report (2011), the growth of the institutional investor’s base “has contributed to maintaining stability and liquidity in the national financial markets”.
|1/ Defined as M3 excluding banknotes and coins.|
The composition of public domestic debt and the set of its investors’ holdings have also changed. As a consequence, these have contributed concurrently to the development of markets. While in 1999 two thirds of the Federal Government domestic debt was placed at floating rate (bondes) and another fourth was short-term (cetes), by March 2014 half of the outstanding balance of government instruments were in fixed-rate and long-term bonds (Chart 1.9). This new composition in the type of instruments placed has meant a significant increase in both the term and duration of the government debt over the last decade and a half. For example, the average maturity date of the government debt increased from 288 to 1,070 days during the period between 1995 and 2004 (Jeanneau and Pérez-Verdía, 2005) and to more than 2,950 days in March 2014 (Chart 1.10). In turn, duration increased from a little more than a year in 2002 to 4.81 years in March 2014. The extension of both maturity profile and duration has significantly reduced rollover and interest rate risks for the Federal Government.
Chart 1.11 illustrates how the investor base has grown. In 2005, the main holder of government bonds was the Mexican banking system, holding 13% of the outstanding total for its own accounts and an additional 39% for various customers (mainly individuals and corporations participating in the market through banks). These two sectors (banks and other) limited their influence by March 2014 by having only 30% of the instrument holdings at that time. As for Mexican institutional investors (Siefores, mutual funds and insurance companies) they kept a share of between 33% and 40% for the period 2005 to March 2014. Meanwhile, foreign investors increased their share in the total of outstanding instruments from 8% to 36% in the same period. This change in the composition of the investor base has provided the Mexican market with more stability and depth, since the most important holders now trade for longer terms. Regarding the most recent expansion of foreign investment in the government bond market, Sidaoui, Santaella and Pérez (2012) tentatively argue that it could be an additional factor contributing to the stability of this market.
The development of the government debt market is reflected in its trading volume (Chart 1.12), which has grown considerably, even in periods of high financial volatility. As for market liquidity, it has increased significantly, as reflected by the lower spreads or bid-ask differentials in government bond prices. In this way, the development and depth of the Mexican securities market, together with its institutional and operational characteristics, allowed the inclusion of government debt denominated in pesos in the main global fixed-income indexes (Table 1.1). This inclusion, in turn, has contributed to a wider participation of foreign investors, from those who passively replicate those indexes, to those who discover these assets by being included in prestigious or globally accepted portfolios.
|Inclusion of Mexican government debt denominated in pesos
in Global Fixed-income Indexes
|Government Bond Index Broad
(JP Morgan GBI - Broad)
|Universal Government Inflation-linked Bond Index
|Government Bond Index EM
(JP Morgan GBI - EM)
|Global Aggregate Index
|Global Government Bond Index
|Global Government Inflation-linked Index
|Global Emerging Markets
|EM Government Inflation-linked Bond Index
|World Government Bond Index
(Citi - WGBI)
|Source: Ministry of Finance (SHCP).|
As mentioned previously, the existence of a risk-free yield curve has been used as a reference by the different issuers. On the one hand, this curve has facilitated the granting of mortgage credits for up to 30 years by financial institutions. This has occurred due to the need to establish long-term, risk-free financing cost, as well as for risk management purposes by banks. On the other hand, some corporations, besides enjoying access to credits through the bank sector, have managed to finance productive projects by issuing bonds and securitizing assets. In fact, the yield curve is the main anchor for floating-rate issues, the most common instrument for corporate issues (Chart 1.13).
Before the 2008 crisis, foreign issues in the “Europeso” market where growing at significant rates based on the domestic market yield curve.
The development of the government debt market in Mexico has also fueled the emergence of the derivatives market. The Mexican Derivatives Market, also known as MexDer, began operations in December 1998. This market, together with its clearing house Asigna Compensación y Liquidación (known as Asigna), are self-regulated bodies operating under the supervision of the Ministry of Finance, Banco de México and the National Banking and Securities Commission (CNBV, for its acronym in Spanish). Having a consolidated derivatives market sets the basis for adequate risk management. Additionally, the derivatives market strengthens the monetary policy transmission channels by allowing an expansion of the credit channel. Finally, thanks to these instruments it is possible to have better financial tools and indicators for the central bank to evaluate market expectations.
As can be seen in Charts 1.14 to 1.17, the most important contracts in MexDer are those of futures for fixed-income securities, among which the TIIE and government bond futures (cetes and bonos) stand out. This market experienced significant growth prior to the 2008 financial crisis, although recently it has been rather modest. In its place, interest rate swaps (IRS), market referenced to the TIIE, have been growing. Being a highly liquid, OTC market, has allowed an efficient hedging of interest rate risk. It is important to mention that this over-the-counter market is quoted outside stock exchanges, like the MexDer.
|1/ March 2014, annual accrued.|
|1/ Includes 3-month cetes and 3-year, 10-year and 20-year bonos.|
As shown previously in Chart 1.1, other free-risk issuers in Mexico include Banco de México and IPAB. The central bank has participated in the debt market through the auction of securities aimed at funding the accumulation of international reserves with long-term liabilities. From 2001 to 2006, Banco de México placed its own instruments but, since then, it has used government bonds. In the case of IPAB, it manages the debt originated by the restructuring and support granted to commercial banks after the 1994-1995 crisis and which were taken over by the Institute. It is for this purpose that IPAB places its own instruments in the debt market.
Maybe the most important consideration regarding other risk-free issuers is that they are perfectly coordinated with the Ministry of Finance in terms of instrument placing. Indeed, coordination among the different issuers has been such that several niches have been reserved for each of them: while the Federal Government has a wider placement of both nominal (short and long terms) and real (only long term) fixed-income securities, Banco de México and IPAB have issued solely floating rate securities. Hence, the three issuers participate in a coordinated way in the quarterly announcements of auctions of securities (where both the intended amounts to place by type of instrument as well as the specific auction calendar for the period are defined).
This chapter discussed the main elements needed for the development of the government debt market, a mainstay for the remaining financial markets in any economy. Then, the strategy followed by the Mexican financial authorities to develop the debt market was introduced, together with its main results. Undoubtedly, the development of the market for instruments issued by the Federal Government has been successful.
The rest of the book provides detailed descriptions of the characteristics of the types of instruments currently available in the Mexican securities market and the way in which they are placed among investors (Chapter 2). Then, it moves to discussing the currently available investor base (Chapter 3) and how the secondary market operates (Chapter 4). The figure of market makers, key to the development of the market, is also analyzed (Chapter 5). It also describes the operation of settlement systems in Mexico (Chapter 6). Finally, relevant regulatory and fiscal aspects are reviewed (Chapter 7) and conclusions are made (Chapter 8).
- BANXICO. Official notice (circular) 1/2006.
- BANXICO. Technical Description of Banco de México’s Monetary Regulation Bonds (Descripción Técnica de los bonos de Regulación Monetaria del Banco de México). 2000.
- BANXICO. Financial System Report. 2011.
- BIS. The role of the central bank in developing debt markets in Mexico. Sidaoui, José Julián. June 2002.
- BIS. Reducing financial vulnerability: the development of the domestic government bond market in Mexico. Jeanneau, Serge and Pérez-Verdía, Carlos. 2005.
- BIS. The impact of international financial integration on Mexican financial markets. Sidaoui, José Julián. January 2009.
- BIS. Banco de México and recent developments in domestic public debt markets. Sidaoui, José Julián; Santaella, Julio, and Pérez, Javier. 2012.
- IBRD/World Bank, IMF. Developing government bond markets a handbook. 2001.
- IMF Working Paper. Managing risks in financial market development: The role of sequencing. Karacadag, Sundararajan, Elliott. June 2003.
- Mohanty and Turner. Monetary policy transmission in emerging market economies: what is new? 2008.
- NBER Working Papers No. 10036. Currency mismatches, debt intolerance and original sin: why they are not the same and why it matters. Eichengreen, Hausmann and Panizza. October 2003.
- Greenspan, Alan (Remarks by Chairman). Do efficient financial markets mitigate financial crises? Before the 1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia. October 19, 1999.
- SHCP. El crédito público en la historia hacendaria de México, sus protagonistas y su entorno. Rodríguez Regordosa, Gerardo. November 2012.
- SHCP. Official notice (Oficio) no. 305.-065/2008.
- Sidaoui and Ramos Francia. The monetary transmission mechanism in Mexico: recent developments. 2008.
- Turner. Bond markets in emerging economies: an overview of policy issues. 2002.
 Claudia Álvarez-Toca has a Bachelor degree in economics (summa cum laude) from Universidad Iberoamericana (UIA) and a Master degree in business administration (summa cum laude), with a major in finance from Instituto Panamericano de Alta Dirección de Empresas (IPADE). Since 2007 she has been senior economist at Banco de México, now reporting directly to the Directorate General of Central Bank Operations. Since she first started working at the central bank in 1993, she has held different positions, always in the Operations Department, among which stands out her position as head of the desk in charge of the implementation of currency exchange policies and later, as head of foreign reserves management. During a period where she worked outside Banco de México (2002-2007), she did so as an academic in Finance at IPADE, where she also held managerial positions and offered consulting services to corporations and individual investors.
Julio A. Santaella-Castell holds a Bachelor degree in economics from Instituto Tecnológico Autónomo de México (ITAM) and a Doctorate in economics from the University of California at Los Angeles (UCLA). He currently is Operations Support Director at Banco de México. Among his main responsibilities are providing economic and financial analysis to the central bank operations, processing all central bank operations, and offering operating systems to perform these operations. Prior to Banco de México he worked at the Ministry of Finance (1984-1987), the International Monetary Fund (1992-1997), and the Instituto Tecnológico Autónomo de México (1997-2001). He is the author of several articles published in academic journals and books.
The authors would like to thank Javier Duclaud, Jaime Cortina and Oscar Palacios for their comments, as well as the valuable technical and research assistance of Claudia Tapia, Rodolfo Mitchell and Germán Mirassou.
 Turner (2002) states that the development drivers for debt markets are specific (related to effectively satisfying credit needs) and general (related to a better market functioning).
 “Before the crisis broke out, there was little reason to question the three decades of incredibly solid East Asian economic growth, largely financed through the banking system. The rapidly expanding economies and bank credit growth kept the ratio of nonperforming loans to total bank assets low. The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat tire. East Asia had no spare tires…” in Greenspan (1999).
 IBRD / World Bank, International Monetary Fund. Developing Government Bond Markets a Handbook. 2001, p.4.
 In the case of Mexico, risk-free issuers comprise the Federal Government, the Bank Savings Protection Institute (Instituto para la Protección del Ahorro Bancario, IPAB), and Banco de México (the central bank also known as Banxico).
 YIELD CURVE: Graphic representation of interest rate levels of different bonds with different maturity terms, but with the same credit rating, in a certain moment. Represented graphically from the shortest to the longest maturity term.
 DERIVATIVE: Security whose price depends on or derives from one or more underlying assets. A derivative is nothing more than a contract between two or more parties. Its value is determined by fluctuations in underlying asset prices. Futures contracts, forwards, options and swaps are the most common type of derivatives.
 For more information on the general theory of monetary policy transmission, see Mohanty and Turner (2008), and for a comprehensive analysis of the monetary policy transmission channels in Mexico, see Sidaoui and Ramos Francia (2008).
 For more information, see IBRD/World Bank, International Monetary Fund (2001), op.cit.
 This was most evident during the recent European crisis, where issuers with high debt indexes lost access to markets.
 For details on the repo market, see chapter “Secondary market” in this book.
 BIS Papers no. 11. The role of the central bank in developing debt markets in Mexico. José Julián Sidaoui, June 2002, p.151.
 In Mexico, competition among different risk-free issuers for the same investments has been prevented by making both government and Banco de México instruments fungibles with each other. For more details, see chapter “Types of instruments and their placement”.
 In the specific case of Banco de México, coordination also includes aspects related to its role as sole financial broker of the Federal Government.
 The term “broad government bonds” is regularly used to refer to the instruments placed by these three issuers and the term “government bonds” corresponds to those issued exclusively by the Federal Government.
 The chapter “Types of instruments and their placement” describes thoroughly the characteristics of the instruments issued by IPAB.
 For more details on the instruments issued by the central bank, see Technical Description of Monetary Regulation Bonds of Banco de México at www.banxico.org.mx. The chapter “Types of instruments and their placement” also refers to the characteristics of bondes D.
 CETES: Federal Treasury Certificates. They belong to the family of zero-coupon bonds, i.e., they are traded at a discount (below their nominal value), bear no interest along their term and their nominal value is settled at maturity. For more information, see the chapter “Types of instruments and their placement.”
 SECONDARY MARKET: Market in which securities already placed are bought and sold and where trades are carried out among investors (instead of being dealt directly with the issuer). For more information, see chapters “Secondary market and “Investor base”.
 For more information, consult the chapter “Investor base”.
 The advocates of this theory argue that this condition increases a country’s vulnerability by being forced to use foreign currencies to finance its debt and to face depreciations in its currency (Eichengreen et al. 2003).
 In the chapter “Types of instruments and their placement”, reference is made to “Transparency and predictability” with more detail.
 The chapter “Types of instruments and their placement” describes in more detail “Reference issues and openings”.
 For more information, see Ministry of Finance official notice no. 305.- 065/2008.
 BONOS: Federal Government fixed-rate development bonds that are issued and placed at terms of over one year, pay interest every six months and their interest rate is determined at issue date and remains fixed all along the life of the bond. For more information, see chapter “Types of instruments and their placement”. Also known as bonos M.
 UDIBONOS: Federal Government development bonds denominated in investment units. They were created in 1996 and protect their holder from unexpected changes in the inflation rate. Udibonos are placed at long terms and pay interest every six months on the basis of a real fixed-interest rate determined issue date. For more information, see the chapter “Types of instruments and their placement”.
 COUPON: The term “coupon payment” is known as an advance interest payment of debt (that is, prior to the instrument’s maturity date).
 The chapters “Types of instruments and their placement” and “Secondary market” describe in detail the stripped instruments auction and the secondary market, respectively.
 SWAP (of instruments): A swap of government bonds is a financial operation through which certain government bonds are swapped or exchanged with other of different characteristics.
 In the chapter “Types of instruments and their placement” “swaps” are described in more detail.
 The chapter “Types of instruments and their placement” describes these “purchases” in more detail.
 In the chapter “Types of instruments and their placement” the “syndication” process is described in detail together with other security placement schemes.
 REPO: Repo operations are those where the repurchasee (lender) acquires credit instruments for a certain amount of money and is obliged to transfer to the repurchaser (borrower) those instruments on a previously agreed date against the same amount of money plus a premium. The chapter “Secondary market” describes extensively repo operations.
 PRICE DISCOVERY: Process through which the price of an instrument is determined considering its supply and demand. The instrument’s price is therefore the result of the appetite for the instrument at any given time and the willingness to sell it by its holders.
 See the chapter “Secondary market” for more details on “Price vendors”.
 This subject is broadly discussed in the chapter “Instruments settlement”.
 The chapter “Secondary market” describes this window in more detail.
 The chapter “Investor base” provides information and charts that show the development of the various investor segments, pension funds included.
 Europesos are instruments denominated in pesos but issued outside Mexico.
 DERIVATIVE: Security whose price depends on or derives from one or more underlying assets. The derivative is a contract between two or more parties. Its value is determined by fluctuations in the underlying asset price. Futures contracts, forwards, options and swaps are the most usual type of derivatives.
 RISK MANAGEMENT: Refers to the process of identifying, analyzing and accepting or mitigating of uncertainty in investment-related decisions. It takes place whenever a potential loss in an investment is quantified in order to take (or not) the proper decision, considering its investment goals and risk tolerance.
 INTEREST RATE SWAP: Agreement between two parties that consent to exchange in the future a series of interest payments for a predetermined nominal amount. Interest rate swaps usually exchange a fixed rate-based payment for a floating rate-based payment (in the case of Mexico, for a TIIE-based payment). A company will normally use these kinds of swaps to limit their exposure to fluctuations in the interest rate levels of their debt.
 The process by which Banco de México acquires government bonds without granting financing to the Federal Government is established in Banco de México’s Law and in the Financial Broker contract signed between Banco de México and the Ministry of Finance (SHCP). These regulations state that Banco de México must match the purchase of government bonds with Federal Government deposits in cash obtained from the placement of the referred bonds. These deposits cannot be used or withdrawn by the Federal Government until the value backing up such deposits matures. For a detailed description of this process, see the box included in the chapter “Types of instruments and their placement”.