* Hedge funds, others made $16 bln in bids
* Deal carries yield under 9 percent tax free
* New bond prices rise in secondary trade
By Michael Connor
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, but investor demand outstripped supply despite the Caribbean island's difficult cash position.
The sale, considered crucial for financial reforms in the U.S. territory, which 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 James Colby, a municipal strategist at Van Eck Global, an operator of two high-yield bond funds that bid on the Puerto Rico deal.
The new bonds were freed to trade late on Tuesday, and they immediately began to rise in price. Yields hovered around 8.4 percent and 8.5 percent, with the lowest reaching 8.352 percent, according to Municipal Securities Rulemaking Board data.
The price Puerto Rico paid to borrow was well below the expectations of 10 percent or higher that prevailed in the market just a few weeks ago.
Still, the rate was enough to attract interest in the bond market, where similarly rated junk corporate bonds yield around 5 percent.
Hedge funds favoring riskier investments had been expected to dominate the sale, with many traditional institutional investors shut out by restrictions on holding municipal 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 worries linger about Puerto Rico's economy, which has been shrinking nearly non-stop since 2006. Puerto Rico suffers from a dwindling population and has unemployment topping 15 percent along with 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 adviser to Puerto Rico bond issuers that some analysts and portfolio managers say may be over stretched.
Puerto Rico's governor, Alejandro Garcia Padilla, said the bond sale was just one step toward bettering the island's finances and said he would announce cost-cutting measures in coming weeks. The governor has promised a balanced fiscal 2015 budget.
"Together we will achieve Puerto Rico's recovery," Padilla said in a statement.
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 general obligation 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 that the government's fiscal reforms have been too weak and saying a future restructuring was "almost a certainty."
Not all were so pessimistic. Dan Hickman, a senior fixed-income strategist at U.S. Bank Wealth Management, said the deal probably buys Puerto Rico about two years of breathing room.
"It just kicks the can down the road," he said, "but it kicks it pretty far."