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UPDATE 2-Moody's follows S&P, cuts Puerto Rico to junk

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.

The agency 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 "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."

Reaction in the $3.7 trillion municipal bond market was somewhat muted as the move was widely expected.

"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 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.

"Funds may need to turn to selling things like tobacco (bonds) in the near term to raise cash, further exacerbating the market condition," Municipal Market Advisors, an independent municipal bond research firm, said.

While traders took the news in stride, 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.

In a separate report dated Feb. 3, Moody's said that one of its market-based measures indicated that Puerto Rico was at a greater risk of defaulting within the next year than all 50 U.S. states and sovereign issuers save Argentina and Venezuela.

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.

HIGH STAKES DEBT SALE

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.

Indeed, the stakes are high for the government's 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. But he said hedge funds that specialize in distressed debt may still be willing to lend to the island.

Puerto Rico bonds have long been popular with U.S. investors because they are tax-free in all 50 states. About 70 percent of municipal-debt mutual funds own the securities, according to Morningstar Inc.

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, Emily Raimes, the lead analyst for Puerto Rico at Moody's, told Reuters.

Puerto Rico Governor Alejandro GarcĂ­a Padilla said earlier this week he would seek to renegotiate swaps agreements and other loans that will require accelerated payments.

"Now it will all be about their accelerated payments - whether they're going to make those payments and whether they have access to the debt markets," Cohen said.

In a joint statement on Friday, Treasury Secretary Melba Acosta Febo and Government Development Bank for Puerto Rico Chairman David Chafey said they "strongly disagree" with Moody's decision and were "confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year, including any cash needs resulting from recent rating agency actions."

TAX-SUPPORTED DEBT RATING CUT

Most market movement was concentrated in the island's sales-tax supported COFINA bonds, which Moody's cut to 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," Cohen said. "But investors are worried....It's not like sales taxes are booming in an economy on its tush."

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