Nov. 13 (Bloomberg) -- Governor Luis Fortuno’s declaration of a fiscal emergency hasn’t deterred investors from buying Puerto Rico’s bonds, whose 20 percent return this year beat debt indexes in every U.S. state tracked by Standard & Poor’s.

Keeping investors interested in the Commonwealth’s $47 billion of debt may depend on the Republican governor’s plan to cut a $3.2 billion budget deficit, revive an economy that shrank 5.5 percent in the last fiscal year and rescue a credit rating one level from high-risk, high-yield junk. Since taking office in January, Fortuno eliminated 22,500 government jobs, riling a constituency that makes up 30 percent of the labor force.

“I’m not here to win a popularity contest,” Fortuno, 49, said by telephone from San Juan during a national strike on Oct. 15, when protesters and police clashed outside the Fortress, his home in the old section of the walled capital founded by Spain in 1521. “I’m here to deliver results.”

Bonds of Puerto Rico, which was ceded to the U.S. in 1898 after the Spanish-American War, are exempt from taxes in any state, unlike most municipal debt. The securities have benefited from record cash flows into municipal-bond funds, masking an economy that contracted in the 12 months ended June 30 at twice the 2.4 percent forecast for the country as a whole in 2009, the median estimate of analysts in a Bloomberg survey.

‘Too Few Bonds’

“I’m happy to have them because there’s a lot of cash chasing too few bonds,” said Michael Walls, who manages the $533 million Municipal High Income Fund at Waddell & Reed Financial Inc. in Overland Park, Kansas. “The more dicey a credit is, the more it’s rallied.” His fund owns Puerto Rico securities backed by sales taxes.

The difference in yield between a 6.5 percent Puerto Rico sales-tax bond sold in June, rated A+ by S&P, and a Municipal Market Advisors’ index of 30-year AAA rated municipal securities narrowed to 45 basis points on Nov. 9 from 100 on Aug. 28, as investors drove prices of the Commonwealth’s securities up and interest rates down more than higher-rated debt. A basis point is one one-hundredth of a percentage point.

The Commonwealth’s debt, including the sales-tax-backed and general-obligation securities rated BBB- by S&P, one step from non-investment grade, returned 20.1 percent this year through yesterday, according to the S&P Puerto Rico Municipal Bond Index. That’s a bigger gain than any of S&P’s 27 state indexes and compares with the 13.3 percent return for the S&P/Investortools Municipal Bond Main Index of all municipal debt, which rose 13.3 percent. S&P’s high-yield muni index increased 33.2 percent.

$55 Billion

A 5.75 percent Puerto Rico general-obligation bond due in 2038 that was priced earlier this month at a discount of 96.59 to yield 6 percent rose as high as 101.35 in the when-issued market to yield 5.57 percent, according to data compiled by Bloomberg. They were offered at 5.9 percent yesterday.

Debt of the Caribbean island, whose population of 4 million is about equal to Kentucky’s, is riding a rally in which investors poured a record $55 billion into municipal-bond mutual funds this year, according to the Investment Company Institute in Washington, D.C.

Fortuno’s so-called fiscal stabilization plan will have to show results soon to sustain the gains investors have recorded, said Matt Fabian, managing director at Municipal Market Advisors, a researcher in Concord, Massachusetts.

“You have a major implementation risk involving how well the plan will do,” Fabian said in an interview. “It’s not a credit that’s out of the woods yet.”

Fortuno, who earned a law degree from the University of Virginia, served as Puerto Rico’s non-voting delegate to the U.S. House of Representatives in Washington before winning the governorship a year ago with 53 percent of the votes.

Shrinking Payroll

He declared a fiscal emergency in March with a plan to curtail public spending, which has boosted borrowing to 83 percent of economic output, according to S&P. That is four times more than Massachusetts, which has more debt as a portion of GDP than any state, with 20 percent in 2007, according to the Tax Foundation, a Washington, D.C.-based research organization.

Fortuno wants $2 billion of spending cuts, mostly through reductions in the Commonwealth’s payroll. He proposed deploying $6 billion of federal stimulus funds and $500 million from his government to employ fired workers on infrastructure projects while trying to lure private companies to maintain employment.

“We’re throwing almost $7 billion out there in the next few months, which is major for our size,” Fortuno said in an interview when he announced the effort.

Stabilization Fund

The governor’s fiscal plan will raise Puerto Rico’s jobless rate by 2 percentage points, said the Government Development Bank, the commonwealth’s borrowing agent. Unemployment was 16.2 percent in September, the highest since May 2006 and more than any state.

To support fired workers’ transition into private employment, Fortuno’s plan includes a $2.5 billion stabilization fund financed by sales-tax-backed bonds sold by the development bank. Carlos Garcia, president of the San Juan-based institution, said $1.5 billion for the fund was raised from a $5.3 billion series of bonds announced in June.

In the interview last month, Fortuno invoked memories of 2006, when government offices shut for more than two weeks until lawmakers negotiated a bailout from the development bank to plug a revenue shortfall.

“We don’t have a choice,” Fortuno said. “I’m not going to allow this place to close down like it did once.”

June Target

While Fortuno demands spending reductions, tax revenue is falling in the self-governing Commonwealth, whose residents pay only local income and sales taxes and no federal income levies. Collections dropped 5 percent in August from a year earlier, the eighth decline in 12 months, according to the development bank.

With unemployment rising and revenue declining, Fortuno suspended government job cuts short of his original target of 30,000, he said in an interview on Oct. 22 at a conference in Fajardo, 30 miles (49 kilometers) east of San Juan. Only $1.2 billion of the governor’s proposed spending reductions have been implemented, with the balance planned by the time the current fiscal year ends next June, the development bank said on Oct. 2.

Such delays aren’t surprising, said Horacio Aldrete- Sanchez, a Dallas-based S&P analyst.

“Balanced budgets won’t be achieved right away,” he said in an interview. “We always assumed it will take several years to achieve fiscal balance.”

Pharmaceutical Jobs

The island’s transformation from agriculture to one where manufacturing provided 46 percent of income in 2002 has stalled because of the global recession and the end of U.S. tax incentives that created 100,000 pharmaceutical jobs in the 1990s, said Miguel Soto-Class, executive director of the Center for the New Economy in San Juan, a private researcher.

More local enterprise is needed, especially tourism, which comprises 7 percent of the economy, he said.

“We consume things we don’t make with money that’s not ours, and you can’t grow an economy that way,” Soto-Class said. “We need a top-to-bottom reinvention of the taxing system to widen the tax base and lower rates.”

The development bank’s Economic Activity Index, which measures employment, cement sales, electricity and gas consumption, rose 0.8 percent in September from the previous month, the biggest gain since October 2006, the institution said Nov. 2. Still, investors are looking more toward reductions in the budget gap, spending and debt.

“The governor has said some strong things about how they’re going to reduce the deficit,” said Doug Nelson, a credit analyst at Waddell & Reed. “I’d like to believe him, but when you look at the history of Puerto Rico, they’ve had a lot of financial difficulties over the years.”

To contact the reporter on this story: Jerry Hart in Miami at jhart@bloomberg.net.

Last Updated: November 13, 2009 10:35 EST