By Steven C. Johnson
NEW YORK, Feb 7 (Reuters) - Moody's Investors Service on Friday became the second ratings agency this week to cut Puerto Rico's credit rating to junk, citing concern about the cash-strapped U.S. territory's weak economy and its ability to borrow.
Reaction in the $3.7 trillion municipal bond market was somewhat muted as the move was widely expected, though a few wild odd-lot trades, while tiny, indicated growing concern about the Caribbean island's ability to meet its obligations.
Moody's said it now rates the commonwealth's general obligation bonds at Ba2, two notches below investment grade and one step deeper into junk territory than Standard & Poor's, which cut the Caribbean island's rating to junk on Tuesday.
With some $70 billion of tax-free debt - nearly four times the $18 billion owed by bankrupt Detroit - Puerto Rico has long been mired in recession and has for months been under threat of a ratings downgrade by all three U.S. credit ratings agencies.
Moody's praised the government's recent attempts to cut spending, reform its pension system and boost growth, but said they are not enough.
"While some economic indicators point to a preliminary stabilization, we do not see evidence of economic growth sufficient to reverse the commonwealth's negative financial trends," Moody's said.
In the municipal bond market, investors said they were not surprised by the downgrade. But a spike in the yields in a few odd-lot trades indicated that some bondholders were demanding greater compensation due to a perception of increased risk.
"You knew it had to happen. We were waiting for this shoe to drop," said Marilyn Cohen, president of Envision Capital Management in Los Angeles. "Now we have to see what mutual funds are not going to be able to hold these bonds now that more than one rating agency has downgraded them."
The yield on a Puerto Rico tax-exempt public improvement refunding general obligation bond maturing on July 1 topped 28.75 percent, compared with 5.48 percent on its most recent previous trading day in late January.
A similar bond maturing this summer carried a yield of over 34 percent in one late trade on Friday, though even at that rate, it was still priced at about 90 cents on the dollar.
Bonds coming due soon are at the "most risk of some kind of potential disruption of payment or restructuring," said Daniel Berger, a senior market strategist at Municipal Market Data, a unit of Thomson Reuters
Fear of an imminent default, as measured by Puerto Rico's one-year credit default swap, remained high.
As of Friday afternoon, it cost more than $22,000 to insure $100,000 of Puerto Rico bonds against default for one year. That was more than it cost to buy five- or 10-year insurance.
The top 10 U.S. mutual funds with the greatest exposure to Puerto Rico have been hit with nearly $3 billion in net outflows over the past year, according to Morningstar, amounting to about a quarter of the funds' combined net assets.
The U.S. territory is not eligible to file for Chapter 9 municipal bankruptcy protection, and the White House has said it is not considering a bailout.
The island of 3.62 million people is facing a steadily declining population and has large unfunded pension liabilities, which have raised doubt about its ability to sell more debt.
Emily Raimes, Moody's lead analyst on Puerto Rico, told Reuters that the commonwealth's failure to sell bonds late last year or so far this year had heightened concerns about its liquidity position.
The government plans to sell up to $2 billion in debt this month, its first foray into the bond market since August.
"There will be people who simply can't participate," said Barry HoAire, a portfolio manager at Bel Air Investment Advisors in Los Angeles, adding that hedge funds that specialize in distressed debt may still be willing to lend to the island.
Puerto Rico bonds are popular with U.S. investors because they are tax-free in all 50 states.
The downgrade could also cost the commonwealth more than $1 billion in penalties and other costs tied to variable rate demand obligations and other securities, Raimes said.
Puerto Rico Governor Alejandro García Padilla said earlier this week he would seek to renegotiate swaps agreements and other loans that will require accelerated payments.
In a joint statement, Treasury Secretary Melba Acosta Febo and the chairman of the Government Development Bank for Puerto Rico, David Chafey, said they "strongly disagree" with Moody's decision and were "confident" about meeting obligations until the end of the fiscal year.
Padilla also criticized the action, citing the recent passage of sweeping pension reforms and other measures that Moody's called for last year.
"It's evident that Moody's Investors Service has abandoned its fundamental role of providing an analysis without prejudice to its clients and has become locked in a game of appearances with its competitors," he said.
Moody's also cut the island's sales-tax supported bonds to the lower investment-grade level of Baa1 from A2.
These securities, issued by COFINA, the Spanish acronym for Puerto Rico's Sales Tax Financing Corp, are viewed as more secure as they are backed by more reliable income streams.
A 2041 maturity COFINA bond with a 5.25 percent coupon from COFINA fell to 65.7 cents on the dollar from as much as 69.4 cents before the ratings cut.
S&P did not cut its rating on COFINA, which is expected to be a primary vehicle for any subsequent bond market sales.
The COFINA bonds have "held up better than most," Envision Capital's Cohen said. "But investors are worried....It's not like sales taxes are booming in an economy on its tush."