The Bond Buyer recently reported on a report from the California Debt and Investment Advisory Commission that discussed the steep drop in CA zero issuance (zeros = cabs = capital appreciation bonds) in 2013. Their chart below shows that issuance is about half of what it used to be.

Act 182, passed in 2013 and effective on 1/2014 prevents CA School districts from issuing cabs with maturities greater than 25 year and it requires issues with maturities greater than 10 year to be callable. Using Bloomberg data as our source, we found that only 100 mlln worth of non callable zeros with maturities greater than 10 years were issued in 2013.

There simply are no more non callable Ca School District bonds being issued!!

In their weekly publications, Citibank's George Friedlander and Morgan Stanley's Ryan Brady both point out the relative cheapness of CA municipal zeros. We could not agree more and have been touting these structures for quite a while. Wall Street now appears to agree with us. Here is what we like:

1) Credit - CA credits are improving dramatically as increased tax receipts have pushed the CA budget into a surplus. The property taxes that secure most of these structures are considered "dedicated" and therefore are not subject to a "stay" in bankruptcy proceedings.

2) Supply - Recent CA legislation prevents school districts from issuing long dated, non callable zero structures.

3) Yields - Long dated zero cpn yields are trading above 5% as compared to the most recently issued CA GO (with a 5% cpn) which ylds 3.90.

Here is a graph of the yield spread between non callable CA zeros and CA cpns: This spread should be closer to 50 not 120!

Governor Padilla and his administration are doing everything they can to initiate a successful takeoff for the PR economy. Padilla's team has spent the last 6 weeks exploring new and innovative growth ideas; including fielding 375 ideas submitted by the public thru their open web forum. These ideas as well as the 2015 budget will all be made public at the State of the Commonwealth address sometime soon. The initial readings suggest that the revenues are in line with the budget estimates.

Regardless, this flight has not started smoothly and the administration is already facing turbulence

1) Before coming to market with a 3.5 blln GO deal on 3/11, the GDB hired Millstein and Co to help them analyze internal cash flows and various deal structures. Millstein has strong restructuring history and the market questioned the GDBs true intentions....slight turbulence.

2) After the new issuance and in line with Governor Padilla's plans to make the public agencies independent, legislatures introduced restructuring legislation and the GDB hired Cleary Gotlieb law firm specializing in restructuring and bankruptcy law.. air pocket and more turbulence.

3) The Teacher's Union successfully challenged their pension reform which essentially converted their defined benefit plan to defined contribution plans. These reforms are critical for the administration to produce future balanced budgets...another air pocket and turbulence.

4) Regardless of the Supreme Court's recent confirmation, the Teacher's successful challenge has created a stir with the Police Unions who will likely challenge the more significant Govt Employee Pension reforms....air bag please.

Although none of the above will effect the current budget and all of them (when resolved) will likely help future budgets, the market is skittish and many of the "weak" hands have traded out of their new issue bonds. We have seen the new issue trade from a high of 97 (8.30) to a low of 86.50 (9.50). This cheapening of 120 bpts has spilled into the Cofina markets as well.

We expect the headlines to be negative right up into the State of the Commonwealth address. Keep the seat belts buckled and have a safe flight.

Puerto Rico successfully issued 3.5 billion in debt on March 11, 2014. Even after increasing the size of the deal from 3 billion to 3.5 billion, the prices quickly traded up from the original 93 dollar price to 97. All in all, from the beginning of the year, yields on existing PR GO debt fell from close to 9.00% to 7.25% after the successful placement of the new deal. Yields have recently backed up to 7.75%. Why.....?

1) Technicals - Part of the new deal was allocated to accounts that wanted to trade the bonds quickly (flippers). As the bonds traded up they sold into the higher bid leaving the dealers long. In addition, there were a quite a few trades that had to be canceled because they were smaller than 100k. In general, these cancellations left the dealer community long bonds as well. The market backed up as the dealer community sold these positions.

2) New Legislation - PR Senators proposed a "restructuring bill" that would allow public agencies to restructure. This spooked investors who interpreted (wrongly in our opinion) that PR was setting the seeds to restructure their GO debt. In order to make the public agencies truly independent of the Commonwealth then this type of legislation is needed and in many ways makes the GO debt stronger, not weaker.

3) GDB Announcement - GDB announced that they were considering issuing a COFINA 3rd lien even after indicating that they had raised all they needed in the new GO deal. These new monies would help the Commonwealth initiate their economic initiatives.

Time will tell if the administration can stimulate new economic growth on the island.