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UPDATE 3-Puerto Rico's 'junk' label no hurdle in $3.5 bln bond sale

* Hedge funds, others made $16 bln in bids

* Deal carries yield under 9 percent tax free

* Puerto Rico bonds rise in secondary trade

NEW YORK, March 11 (Reuters) - Puerto Rico on Tuesday sold $3.5 billion of junk-rated bonds at a surprisingly low tax-free interest rate under 9 percent, which was still high enough to tempt investors to snap up the bonds despite the Caribbean island's difficult cash position.

The sale, which was crucial for financial reforms in the U.S. territory that has $70 billion of outstanding debt, was priced in a single 2035 maturity with an 8 percent coupon and an approximate yield of 8.727 percent.

Bigger than an initially planned $3 billion, the sale was oversubscribed, attracting orders worth more than $16 billion from 270 different accounts, according to the island's Treasury. It drew scores of hedge funds and other non-traditional buyers eyeing fat yields and possible trading gains.

"At least for the time being, they found the right combination of product structure to entice (investors)," said municipal strategist James Colby at Van Eck Global, an operator of two high-yield bond funds that bid on the Puerto Rico deal.

Initial price talk on Monday had the bonds being offered in a yield range of 8.625 percent to 8.875 percent, well below expectations of 10 percent or higher for the debt rated non-investment grade by Wall Street credit agencies that prevailed in the market weeks ago.

Such yields are hard to come by for fixed income investors. Similarly rated junk corporate bonds yield around 5 percent.

Hedge funds favoring riskier investments had been expected to dominate the sale, with many traditional municipal bond institutional investors shut out by restrictions on holding bonds rated below investment grade.

The deal was oversubscribed partly because new deals in America's $3.7 trillion muni market have been scarce and the new bonds promise hedge funds liquidity and price movements, said John Mousseau, director of fixed income at Cumberland Advisors in Vineland, New Jersey.

But some worries linger about Puerto Rico's economy, which has been shrinking nearly non-stop since 2006 and suffers from a dwindling population, high unemployment now topping 15 percent, and chronic government budget deficits.

"The deal buys Puerto Rico time to do what they have been doing: lowering deficits, improving business conditions, reforming taxes," Mousseau said. "But it doesn't improve the economy."

In San Juan, Puerto Rico finance officials said the commonwealth expected net proceeds from the sale of $3.2 billion would be used to refinance $900 million of short-term obligations and swap agreements.

The bulk would be used to refinance other debts and raise liquidity by $1.9 billion at the island's Government Development Bank, a key lender and advisor to Puerto Rico bond issuers that some analysts and portfolio managers say may be over stretched.

Puerto Rico's government debt dwarfs that of any U.S. state on a per capita basis but has long been popular among mainland investors for high yields that are free of state, local and federal income taxes.

Puerto Rico had warned in an unusually lengthy list of investment risks published ahead of the offering that it may have to eventually restructure the commonwealth's entire debt portfolio. Last week Puerto Rico hired a restructuring expert as its financial adviser.

The territory cannot file for bankruptcy under U.S. law.

Puerto Rico, whose officials said they still have authority to issue as much as another $900 million in GO bonds, will likely be back to the market soon, according to Nick Venditti, a portfolio manager at Thornburg Investment Management in Santa Fe, New Mexico who did not participate in the sale.

Puerto Rico remains a weak credit, as illustrated by a provision in the deal that allows investors to sue the commonwealth in New York courts, Venditti said.

"The question becomes, if these investors needed a super-senior structure to buy $3.5 billion, what is the next round of investors going to need ...? Venditti said, adding the government's fiscal reforms have been too weak and that a future restructuring was "almost a certainty."

After the sale, secondary trading in Puerto Rico debt turned active.

"The fact that this deal is complete, it takes risk off the table for the near term. It at least postpones it. That should be reason enough to get some rally in prices," said Matt Fabian, a managing director at Municipal Market Advisors.

Some big blocks of bonds traded at higher prices as some investors who may have been waiting to sell took advantage of better conditions.

Large blocks of Puerto Rico's zero-coupon sales tax financing corporation, issued in 2007 maturing in 2043, traded several times on Tuesday, hitting 14.798 cents on the dollar with a yield of 6.61 percent. Those bonds tend to usually trade lower, closer to 12 or 13 cents on the dollar, hitting 14 cents only a couple times since December in significantly smaller trades.

A price rally is likely to provide an exit point for investors who have been waiting to get out of their Puerto Rico positions, Fabian said.