ANALYSIS-Puerto Rico: Vacation oasis, muni-market trouble spot
* Economic slowing worries investors
* Rating downgrade looms
June 25 (Reuters) - Puerto Rico's turquoise Caribbean waters lap white sandy beaches under year-round sun, making the island a safe place to relax.
But beyond its shoreline, U.S. investors see a threatening view, a tropical version of a near-bankrupt industrial city - Detroit, whose stressed finances are run by a state-appointed manager.
"A lot of the same drivers that have been going on in Detroit are at work in Puerto Rico," said Robert Donahue, of Municipal Market Advisors, Inc, pointing to an underfunded government pension system, a shrinking population, heavy borrowing and an eroding tax base.
Credit agencies hold Puerto Rico debt just a step above the junk level with a negative outlook, meaning that another cut is possible. Donahue said receivership may be in the cards adding, "the political system is not solving the problems."
OCEAN OF DEBT
The fourth-largest Caribbean island, the Commonwealth of Puerto Rico stands at the crossroads between North and South America and is a U.S. territory that has flirted with becoming the 51st state. Its residents are U.S. citizens but are unable to vote in federal elections; they also do not pay federal income taxes.
After a federal tax exemption for U.S. corporations based in Puerto Rico was phased out, the island's economy fell into a deep recession in 2006. There was an uptick for much of 2012, but the commonwealth's economy has been shrinking for six months. Some forecasters see that continuing in 2014.
Meanwhile, it has been financing its budget deficit with debt. As a result the debt has nearly tripled from $24 billion in 2000.
Moody's Investors Service calculates Puerto Rico's net tax-supported debt is $14,053 per capita, nearly 10 times the U.S. state average. By comparison, Illinois, a state with an outsized level of debt and big pension problems, last year had net debt of $2,526 per capita.
Puerto Rico 10-year bonds yield more than three percentage points over typical triple-A-rated issues. Illinois, judged the second-riskiest borrower, pays less than half Puerto Rico's premium.
As a result, mainland investors have snapped up Puerto Rico debt, which is exempt from federal, state and local taxes, building a mountain of debt that is 2 percent of the $3.7 trillion U.S. municipal bond market.
These days, there are fewer and fewer people to pay off the debt.
Puerto Rico's population has shrunk more than 3 percent from a peak of 3.8 million in 2000 and its unemployment stood at 13.4 percent in May, higher than any U.S. state.
While Puerto Rico's economy has historically tracked the U.S. economy, economists say that is no longer the case. Now, it is following the Caribbean region, where growth is faltering.
Gustavo Velez, chairman and founder of independent consultancy firm Inteligéncia Económica in Puerto Rico, forecasts the economy will shrink 0.8 percent in the next fiscal year. In the worst-case scenario, he said the economy could shrink up to 1.7 percent compared with the Puerto Rico Planning Board's forecast of 0.2 percent growth.
"The market is ignoring the potential extent of the problem," said Peter Hayes, who helps manage $114 billion of assets as head of municipals at BlackRock and sees debt restructuring as one possible outcome.
PADILLA TO THE RESCUE?
The 2012-elected governor, Alejandro Garcia Padilla, has been praised for his rigorous budget and for a sweeping reform of public pensions. The reform was approved earlier this year, but the $35 billion of pension debt will remain for years.
Padilla and legislative leaders are set to approve later this week an on-time $9.8 billion budget and have agreed to raise taxes by $1.5 billion in the fiscal year starting July 1, a sign of fiscal discipline welcomed by credit agencies.
But Puerto Rico has not been to the municipal bond market in over a year, and financial transparency is clouded because the government has yet to file its consolidated, audited financial report from fiscal year 2012 that ended June 30, 2012. The deadline was May 1, but the audit is now pledged by July 30.
Puerto Rico's government and its financing arm, the Government Development Bank, plan to refinance up to $3.4 billion bonds in 2013 on a bond market dominated by rising interest rates, as the Federal Reserve is seen abandoning years of relaxed monetary policy.
About 60 percent of the Puerto Rico's debt matures in 10 years to 30 years, and it is not under any imminent threat of being placed in receivership.
"A lot of pieces have to fall into place for receivership to happen. It's a little premature to speculate as to when it would happen. The situation has to devolve into a real crisis in which the government is not able to meet its obligations and operating expenses," MMA's Donahue said.
And if there was a crisis, would the federal government ride to the rescue? Unlikely, said Alan Schankel, managing director at Janney Capital Markets.
"In today's contentious (Washington) D.C., there's no way they would," he said. "The federal government would provide some help, but I don't think it would be big and in the form of a bailout. They are letting Detroit go it alone."
INVESTMENT FUNDS HAVE ALREADY SOLD
Investors are already leaving Puerto Rico, partly over fears that bond ratings will be cut to junk status.
Mutual funds, in the year through March 31, reduced their overall exposure to Puerto Rico, according to Lipper. Total Puerto Rico debt holdings among more than 400 funds tracked by Lipper shrank to $11.9 billion at the end of the first quarter of 2013 from just under $13 billion as of March 2012.
All three major rating agencies have Puerto Rico on a negative outlook, and the market is bracing for action.
"Even if only one agency were to take them to non-investment grade, we think it could have a tremendous impact," said Lyle Fitterer, Wells Fargo Advantage Municipal Bond fund manager.
(Reporting by Michael Connor, Tiziana Barghini, Additional reporting by a Reuters correspondent in San Juan; Editing by Peter Henderson and Leslie Gevirtz)