(Adds PREPA bond payment due Tuesday, analysts' comments, recent economic activity)
By Tim McLaughlin and Lisa Lambert
June 30 (Reuters) - Puerto Rico's financial troubles worsened on Monday after mutual funds holding about $1.7 billion of its debt sued the commonwealth, while investors continued to dump debt sold by the island's public corporations.
The flashpoint for the lawsuit brought by two large institutional holders is a law passed last week allowing the U.S. territory's public corporations - primarily its electric power authority known as PREPA - to restructure their debt. The law sparked a sharp selloff in these agencies' bonds that extended on Monday.
Under its constitution, Puerto Rico, one of the largest issuers of municipal bonds, does not have the power to enact a bankruptcy law to adjust its debt, but island authorities say the entities in question are not subject to that rule.
The mutual funds disagree and their reaction raised the possibility of a protracted legal battle over Puerto Rico's obligations to debtholders. Their complaint contends Puerto Rico passed an act modeled after title 11 of the U.S. bankruptcy code used by corporations to reorganize.
The newly enacted law specifically excludes the commonwealth and the Government Development Bank. Still, it has stoked concerns about the potential restructuring of commonwealth debt.
On Monday, Puerto Rico's financial leadership said the law "in no way indicates any shift in Puerto Rico's historical and constitutionally supported commitment to honoring its financial obligations."
But Duane McAllister, a fund manager at BMO Global Asset Management in Milwaukee, said investor perception was key.
"The fact that the target is the public corporations today leads to the view that, if it is insufficient, maybe other debt that is viewed more securely may ultimately be challenged," he said.
Standard & Poor's Ratings Service on Friday put the entire commonwealth's general obligation and appropriation debt under review for potential downgrades. On Monday, it added the Puerto Rico Aqueduct and Sewer Authority (PRASA). That authority has said it will not restructure.
Years of population decline and economic weakness have taken a toll on Puerto Rico, saddling it with about $70 billion of debt and shrinking its revenue. Governor Alejandro Garcia Padilla signed a law declaring a fiscal emergency less than two weeks ago, and this spring, after all three rating agencies had cut its credit score to junk, the territory hired Wall Street restructuring consultants.
On Monday, the governor blamed former commonwealth administrations for allowing the corporations to overspend.
"My administration is not going to permit our families to suffer because of the wrong decisions of the past nor let old debts restrict the economic revival of the country," he said.
PRASA, PREPA and the Highways and Transportation Authority have a combined $20 billion of debt outstanding.
Moody's Investors Service said on Monday the law shows the commonwealth's "diminished willingness" to support the corporations.
Bond funds run by OppenheimerFunds, a unit of insurer MassMutual Financial Group, and Franklin Templeton, filed an amended complaint against the commonwealth on Sunday in U.S. District Court in Puerto Rico.
Franklin Funds, a unit of Franklin Resources Inc, holds about $907.2 million of PREPA revenue bonds and Oppenheimer's Rochester funds hold about $821.4 million of PREPA bonds, according to the complaint.
In Monday trading, yields on PREPA revenue bonds reached a record high of 14.864 percent, or 36.875 cents on the dollar.
PREPA is facing the expiration of millions of dollars in lines of credit. If it cannot extend the lines, the GDB may not have enough cash to keep it afloat.
PREPA also has a bond payment of approximately $204 million in principal and $179 million in interest due Tuesday, according to Fitch Ratings. David Millar, a Puerto Rico government spokesman, said "the trustee has sufficient funds" to cover it.
PREPA could eventually default, said Western Asset Management Portfolio Manager Robert Amodeo in an interview with Reuters Insider. reut.rs/1jCZDD2
The fate of the credit line extensions will determine whether PREPA restructures, said a person close to the matter, adding the GDB will not lend large amounts for fear of becoming insolvent itself.
Since the law passed, the price of PREPA bonds maturing in 20 years or beyond has dropped by about 15 percent, according to the funds' complaint. It added the price of bonds maturing over the next four years had fallen as much as 40 percent.
Conversely, prices on $3.5 billion of junk bonds Puerto Rico sold this year have rallied because investors now expect the commonwealth to not bail out its public corporations. On Monday the price of those bonds rose to 90.5 cents, yielding 9.016 percent.
"A case can be made that isolating the problems of an issuer such as PREPA from the Treasury strengthens the central government," said Alan Schankel managing director at Janney Capital Markets in a note on Monday. "But ... it calls into question political leaderships' willingness to stand by other debt, including GOs."
Bond insurers with exposure to Puerto Rico were also hit. MBIA Inc shares fell 4.9 percent on Monday while Assured Guaranty was down 1 percent. (Additional reporting by Karen Pierog in Chicago; Nicholas Brown and Edward Krudy in New York; Reuters in San Juan; Editing by Tom Brown and Andrew Hay)