Oct. 30 (Bloomberg) -- Mexico’s dollar bonds are posting their biggest monthly declines since January on speculation President Felipe Calderon will fail to cut the budget gap enough to avoid a credit-rating downgrade.

The debt lost 2 percent this month, compared with a drop of 0.5 percent for JPMorgan Chase & Co.’s benchmark emerging-market index. Credit-default swaps, contracts investors use to protect against non-payment, show Mexico trading as high-yield, or junk -- placing it three levels below the nation’s BBB+ grade from Standard & Poor’s and Fitch Ratings.

Investors are unloading Mexican bonds as the opposition- controlled congress challenges Calderon’s plan to increase taxes and narrow a budget gap that RBS Securities Inc. says will grow to the widest in two decades on tumbling oil revenue. The legislative fight compounds concerns after the economy was the hardest hit in Latin America by the global recession that started in the U.S., the buyer of 80 percent of Mexican exports.

“Mexico is more vulnerable than the rest,” said Jonathan Binder, who manages $350 million of emerging-market debt at Consilium Investment Management in Fort Lauderdale, Florida and sold his Mexican holdings in the past three months on concern the ratings will be cut. “I expect more underperformance.”

Nafta

Mexico, which in 2000 became the second country in Latin America after Chile to earn an investment-grade rating as the North American Free Trade Agreement increased exports to the U.S., now has a negative outlook from both S&P and Fitch. The rating companies say they may downgrade Mexico should the government fail to contain the deficit. Moody’s Investors Service rates Mexican debt Baa1, also three levels above junk.

Mexico’s $1.09 trillion economy shrank 10.3 percent in the second quarter and will contract as much as 7.5 percent this year, the most since the 1930s, according to the central bank.

The government’s dollar bonds have returned 7.1 percent in 2009, lagging behind the 24 percent return in JPMorgan’s EMBI+ index. This month’s drop is the worst since a 4.4 percent tumble in January, according to JPMorgan indexes. The extra yield investors demand to own Mexican bonds instead of U.S. Treasuries has narrowed 1.83 percentage points to 1.93 points this year -- less than the 3.67-point drop in the spread on bonds in the EMBI+ index.

Calderon, 47, said Oct. 29 that the country’s “vulnerability is very high,” blaming business leaders for lobbying against higher taxes.

‘Unprecedented Blow’

“It’s not that the president says it,” Calderon said in Mexico City. “You can look at the exchange rate, country risk on Mexican bonds, comments from the rating agencies, which clearly know that we’ve had a severe and unprecedented blow to our public finances.”

The government projects this year’s budget shortfall will total 2.1 percent of gross domestic product and grow to 2.5 percent next year as the drop in oil production and recession erode tax revenue, according to Calderon’s proposal.

Benito Berber, an economist with RBS Securities in Stamford, Connecticut, estimates the 2009 budget gap will equal about 2.8 percent of GDP, the widest since it reached 4.7 percent in 1989.

Oil, which funds 38 percent of Mexico’s budget, has fallen 48 percent since reaching a high of $147.27 a barrel in New York on July 11, 2008. Output at state-owned Petroleos Mexicanos fell last year at the fastest rate since 1942, costing Mexico 300 billion pesos in lost revenue, according to Finance Minister Agustin Carstens.

Consumption Tax

The 2010 budget proposal calls for spending cuts of 218 billion pesos ($16.5 billion). The lower house voted down a 2 percent consumption tax, which accounted for about two-fifths of the government’s new revenue proposals, and scaled back others. The Senate, which has until tomorrow to approve the revenue portion of the budget, plans further changes to the new tax measures.

“There’s a lot of cooks in this kitchen and unfortunately for Mexico it’s all playing out very publicly,” said Blaise Antin, managing director of emerging-market research at TCW Group Inc. in Los Angeles. “That’s obviously not supportive of asset prices.”

Congress has until Nov. 15 to vote on the spending portion of the budget.

“The soap opera in Mexico is going to last another month,” said Sergio Trigo Paz, who manages $2.8 billion of emerging-market fixed-income assets, including Mexican debt, as chief investment officer at Fortis Investments in London. “Market participants are tired.”

IMF Line

The cost of protecting Mexican debt against default for five years is 1.69 percentage points, according to data compiled by CMA Datavision. By comparison, it costs 1.65 points to protect securities issued by Colombia and 1.57 points to protect bonds sold by Panama, countries that S&P rates three levels below Mexico at BB+.

A basis point equals $1,000 on a swap protecting $10 million of debt against default. Credit-default swaps, conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Mexico’s peso is up 3.6 percent to 13.1977 per dollar this year, the second-worst performer after Argentina’s peso among the major Latin American currencies. It plunged 20 percent in 2008 and sank to a record 15.5892 amid the global credit crisis in March, prompting Calderon to turn to the International Monetary Fund for a $47 billion credit line.

‘Comfortable’

The economic slump and downgrade concerns also are eroding demand for corporate debt. Mexican companies sold $5.9 billion of bonds in international markets this year, compared with $19.1 billion by Brazilian companies, data compiled by Bloomberg show. That’s the biggest disparity in corporate debt offerings from the region’s two largest countries since at least 1999.

“If you’re not positive on Mexican growth, why would you take credit risk there?” Fortis’s Paz said. “We’re avoiding corporate credit risk in Mexico.”

Paz said a credit-rating downgrade “is priced in” for Mexican government debt and the worst of the declines are over. As recently as Oct. 6, Carstens said he expected Mexico to maintain its current credit rating.

“I feel comfortable that we will be able to keep our rating,” Carstens said in an interview in Istanbul. He said the officials he met from ratings companies reacted favorably to the government’s budget plan and that, even if it slows the economic recovery, will help attract investment that fell 12.7 percent in June from a year ago.

Pre-Crisis Growth

Paulo Leme, the chief Latin America economist at Goldman Sachs Group Inc., said Mexican growth will rebound next year as the U.S. economy recovers. The peso is up 2.4 percent this month, the second-biggest gain among the 16 major currencies traded against the dollar, amid signs of a pickup in the U.S.

“The country will get back to pre-crisis growth next year,” Leme said in a telephone interview from Miami. “Mexico has highly skilled labor, good entrepreneurs, and a good location.”

Morgan Stanley, UBS AG, Bank of America Corp., RBC Capital Markets and Banco Santander SA all said this month that Mexico is likely to be downgraded.

Lisa Schineller, an S&P analyst, called the lower house’s rejection of the 2 percent consumption tax a “lost opportunity” in an Oct. 21 interview. Both Schineller and Shelly Shetty, an analyst at Fitch Ratings in New York, said in interviews this week that the companies are waiting to see the final budget before deciding whether to cut the rating.

“The real question is whether the tax package will go far enough,” Shetty said in an Oct. 28 telephone interview.

To contact the reporter on this story: Lester Pimentel at lpimentel1@bloomberg.net; Catarina Saraiva in New York at asaraiva5@bloomberg.net

Last Updated: October 30, 2009 17:09 EDT