* Deal will come with big tax-free yields
* Bulk of bond proceeds to go for refinancing
* Officials hope GO deal will be only one in fiscal 2014
By Michael Connor
Feb 18 (Reuters) - Puerto Rico on Tuesday said it will soon sell $2.86 billion of bonds, an offering likely to require sky-high interest rates to offset the taint of the Caribbean island's junk-bond status and worries about possible debt restructurings.
Officials briefing investors, who have driven up Puerto Rico's interest rates since September, said the general obligation offering should come to market in March and will include bonds to refinance existing debt.
The island already has outstanding debt of about $70 billion and pays by far the highest tax-free rates of any big municipal bond seller. Its economy is in a nearly unbroken eight-year recession, which fuels population losses and high unemployment.
Among U.S. states, only California and New York have larger debt burdens, though both have considerably larger populations. And Puerto Rico's debt load rests on an economy that has been shrinking almost continuously since 2006. (Video:)
Puerto Rico's general obligation debt this month was cut to junk status by three top Wall Street ratings agencies, making it harder for the cash-strapped commonwealth to raise money at affordable rates.
Jose Pagán, interim president for Puerto Rico's Government Development Bank (GDB), told reporters he expects Puerto Rico will have to pay above 9 percent on new bonds.
Wall Street credit agencies worry about the government's short-term liquidity, or ability to pay bills such as the $3.44 billion of bond payments Moody's Investors Service calculates are due in 2014.
The White House has repeatedly said it would not come to the commonwealth's rescue, and Congress is not likely to authorize a bailout.
But Puerto Rico's second-largest revenue source last month, an excise tax, has been labeled by some a "backdoor bailout" because it allows U.S. corporations operating on the island - mostly pharmaceutical and medical device firms - to take a credit against their federal taxes.
Puerto Rico Treasury Secretary Melba Acosta, however, said the government had no plans to raise that tax.
Puerto Rico's ability to issue new debt will have important implications. The commonwealth's bonds make up about 2 percent of the $3.7 trillion municipal bond market and are popular with investors and fund managers because they are exempt from federal, state and local taxes.
"The question is how much will they be able to borrow," said Alan Schankel, a municipal bond strategist at Janney Montgomery Scott. "It seems to me that there is enough demand from what I've heard to do a deal of at least $1 billion in size and maybe more."
Linda Murphy, a credit analyst for Puerto Rico at T. Rowe Price, said investors would "look the other way" if yields were high enough.
On Tuesday some of the sky-high yields Puerto Rico bonds had seen in the secondary market began drifting down. Municipal Securities Rulemaking Board data shows that a customer sold heavily traded general obligation bonds that mature in 2016 with a yield of 13.929 percent. Two weeks earlier, a customer sold the same bond with a yield of 17.785 percent.
In the investor presentation, Governor Alejandro Garcia Padilla and finance officials listed tax hikes, pension systems overhauls and spending cuts taken in the last year as illustrations of the government's will to honor its debts.
"The commonwealth has demonstrated it has the political will to address long-standing fiscal and economic challenges," GDB Chairman David Chafey said. "We are nonetheless very aware and clear about the challenges that remain."
Saying next month's bond sale would address Puerto Rico's liquidity needs through June 2015, Chafey told investors the government plans to reform public corporations, such as the island's Electric Power Authority, so the big revenue bond sellers operated more efficiently.
Much of the money raised in the GO deal would go to repay and refinance outstanding debt. About $1.175 billion would likely be used to restructure GO debt service and another $540 million to refund floating-rate bonds and related swap agreements.
Officials also told investors Puerto Rico hopes to only tap the muni bond market once this fiscal year ending June 30, saying they did not have plans to sell bonds beyond its GO package.
In addition, the officials said, Puerto Rico is negotiating daily with its counterparties to swap agreements and other commitments that had potential penalties touched off by the ratings agencies' downgrades.
Puerto Rico has already received a waiver of $400 million in highway obligations and is at an advanced stage of negotiations to renew or waive acceleration provisions in $526 million of the Puerto Rico Electric Power Authority's working capital lines, officials said during the investors webcast.
Fitch Ratings on Tuesday cut the rating on $8.7 billion in Puerto Rico Electric Power Authority revenue bonds to BB+, one notch below investment grade. The move came a week after it cut Puerto Rico's general obligation debt.