By Michael Connor
NEW YORK (Reuters) - Standard & Poor's on Tuesday cut Puerto Rico's credit rating to junk status, making it harder for the cash-strapped Caribbean island to borrow in America's $3.7 trillion municipal bond market.
The move was the latest blow to an economy that has been battling chronic recession, population decline and a perennial budget shortfall that has left it with $70 billion in debt.
It also comes as the U.S. territory is preparing to return to the bond market this month for the first time since August with plans to raise as much as $2 billion. The downgrade is likely to make borrowing more expensive, and it could also curb demand.
"Now you're removing potentially a chunk of the investor community," said James Colby, Van Eck Global chief municipal strategist. "It does raise the bar, not to mention raise the cost of capital."
S&P now rates the commonwealth "BB+," or one level below investment grade, a standing that may oblige some institutional investors to dump holdings of Puerto Rico's high-yielding debt.
Puerto Rico's bonds are popular with U.S. investors because they are tax-free in all 50 states and offer high yields. About 70 percent of municipal-debt mutual funds own the securities, according to Morningstar Inc.
Some Puerto Rico municipal bond yields rose above 10 percent after the late-afternoon ratings cut. A general obligation refunding bond maturing in 2036 hit a yield of 10.16 percent after trading at 9.66 percent earlier in the day, though trading volume was extremely light.
"A lot of it was priced in," said Barry HoAire, portfolio manager at Bel Air Investments in Los Angeles. "But the big concern is what is this going to do to Puerto Rico with respect to margin calls and how does that strain their financial flexibility going forward."
S&P, which had previously rated Puerto Rico "BBB-", said the downgrade may cost the island some $940 million for penalties and other costs tied to variable rate demand obligations and other securities.
Analysts divided over whether or not the demotion of Puerto Rico to junk bond territory will fan anew the fears of municipal bond investors about other hard-pressed muni borrowers.
"People realize Puerto Rico is a one-off situation," said Gary Pollack, head of fixed-income trading at Deutsche Bank in New York. "While it has some problems common to other municipalities, its stature as an island economy with a below-average economic base and some fiscal hurdles make it somewhat unique."
GOVERNMENT SEEKS TO REASSURE ISLANDERS
S&P Primary Credit Analyst David Hitchcock said Puerto Rico's rating would remain in junk territory even if the island manages to sell bonds in the weeks ahead.
If the commonwealth fails to find buyers, it would face further downgrades by the end of the month, he said.
Puerto Rico Governor Alejandro Garcia Padilla reassured island residents in a news conference in San Juan that the island's government would function normally and that he would press ahead with economic development efforts.
"My administration is not responsible for this downgrade, but as a governor, I am responsible to lead (Puerto Rico) out of it," Garcia Padilla said.
Puerto Rico finance officials said they were confident the island had sufficient liquidity until June 30.
Puerto Rico's shrinking economy has for months been under threat of a ratings downgrade by all three U.S. credit ratings agencies. Moody's and Fitch Ratings have not announced ratings decisions.
S&P said it worried that Puerto Rico, with 3.62 million people, has limited ability to sell more debt and faced possible cash shortages.
"We believe these liquidity constraints do not warrant an investment-grade rating," S&P said in a commentary.
S&P, which also cut its rating on the island's fiscal agent, the Government Development Bank, to BB, said that all of its revised Puerto Rico ratings remain on negative watch.
The timing of S&P's downgrade, coming just 11 days after the agency announced a review, was unexpected. Analysts at Moody's have been reviewing the island's finances for a possible downgrade since December 11 and have yet to finish.
"If we have enough information to take action, we have to release it; otherwise we're holding on to inside information," Hitchcock said in an interview.
"We do have confidential information on GDB cash flows and liquidity, and, based on the information that we do have, we feel that we had to take action."
(Additional reporting by Dan Burns, Steven C Johnson, Edward Krudy and Hilary Russ; editing by G Crosse and Cynthia Osterman)