Without a fix, Puerto Rico's $65.3 billion in outstanding bonds may become difficult to sustain in the long run.

Puerto Rico is a prominent, popular seller of muni bonds. U.S. investors like the debt's fat yields, which come with unusual full exemption from federal, state and local income taxes. The island sold $4.82 billion of bonds in 2012's first four months, or 40 percent more than California.

But with debt equivalent to 103 percent of its annual gross product, the U.S. territory carries a burden that would make troubled states like California and Illinois blanch. The two states' debt levels are just under 5 percent of economic output.

To raise funds, Puerto Rico's government hopes to make tourism as important to the island as in Florida, where about 10 percent of the economy comes from vacationers. Tourism currently accounts for just 6 percent of Puerto Rico's economy, with 3.7 million tourists a year, below nearby Dominican Republic's 4.12 million.

Puerto Rico worries some institutional investors, who are concerned by government budget deficits, an economy struggling to exit a six-year recession and under-funded public pensions.

"They have not done enough to go after their structural imbalances," said portfolio manager Robert DiMella, who co-manages $5 billion in high-yield and other muni debt for the MainStay funds run by the MacKay Shields unit of New York Life. "We are extremely low, close to zero, on Puerto Rico."

Yields on the island's BBB-rated debt, even with 10-year maturities paying on average 2.2 percentage points more than the safest bonds, are not enough to compensate for possible defaults and downgrades, according to DiMella.

Among other big U.S. muni bond issuers, only California, with an economy 30 times the size of Puerto Rico's, and Illinois pay interest-rate spreads close to as wide as to the islands.

HIGH JOBLESSNESS, BIG DEFICITS

Puerto Rico has so far had a rough 21st Century. The island's jobless rate is at 15 percent rate, nearly double the U.S. unemployment rate.

Chronic revenue shortages and budget deficits, sometimes filled with the sort of one-time windfalls and loans that trouble bond analysts, grew to a peak of $3.3 billion in 2008, a year before Luis Fortuno became governor and championed spending cuts, tax reform and privatization deals.

Fortuno, who is seeking a second term in November, has eliminated some 20,000 government jobs and reduced Puerto Rico's yearly deficit by 90 percent to a projected $333 million in the next fiscal year.

"Their financial management is much better than they have seen in the past," said portfolio manager Chris Ihlefeld of Thornburg Investment Management in Santa Fe, New Mexico. "The question is, 'Is it too little, too late?'"

But some professionals, including specialists in riskier, high-yield municipals, won't go near Puerto Rico debt. Some seem to be betting against the island, judging by trading in Puerto Rico municipal credit-default swap contracts.

Since early January, the cost for one-year CDS on 10-year Puerto Rico debt has shot up to 482 basis points from 391, according to data-services group Markit. That adds $91,000 to fees now close to half a million dollars to secure shelter against a possible default on $10 million of Puerto Rico debt.

Costs on comparable California CDS dropped $48,000 to $229,000 from early 2012 and eased $11,000 for similar Illinois issues, to $279,000, according to Markit.

By many financial measures, Puerto Rico is an outlier. Its net tax-supported debt in 2010 equalled $10,474 per person, compared with a U.S. per capita mean of $1,408, $2,542 in California and $2,383 in Illinois.

Puerto Rico's debt calculated as a percentage of personal income was 71 percent. The comparable U.S. mean was 3.5 percent, California's 6 percent and 5.7 percent for Illinois.

MORE FEDERAL SUPPORT?

In the new century, Puerto Rico's economy has grown increasingly reliant on federal government payments, such as Social Security benefits, and may be especially vulnerable to cutbacks in U.S. spending.

The island's net payment inflows from Washington in 2010 were $12.2 billion, or equal to nearly a fifth of the island's gross product that year of $63.3 billion, according to U.S. Census data. In 2000, net federal transfer payments were under 13 percent of Puerto Rico's gross product.

"There is a school of thought that the feds would bail out Puerto Rico," DiMella said. "We don't believe that."

Puerto Rico's ailing pension system also worries investors, who want the government to tackle a forecast $24 billion gap between promised payouts and assets. Fortuno pledged to bond investors on May 10 to roll out pension fixes this year.

Fortuno said no options, including the possible issuance of pension-obligation bonds, have been eliminated. Proposals under review include hikes of 0.25 percent in employee-contributions annually over several years, and raising retirement ages.

Ten years ago, the main pension fund had 23 cents for every $1 it needed to pay out, and this year it has just 8.5 cents for every $1. The typical mainland government-workers pension fund has 75 cents for each $1 promised retirees.

DiMella said he sees at best a slow recovery from Puerto Rico's recession, one so hard on job seekers it helped drive a 2.2 percent drop in population, to 3.72 million, in the last decade. Taxes will not be enough to service debt and run the government, even with spending cuts, DiMella said.

He discounts as overblown predictions Puerto Rico's finances will swell into a crisis as severe as Greece's. But he says investors' interest in the island's debt can suddenly dry up.

Puerto Rico is unlikely to default on any bonds but will need to extend maturities or otherwise restructure some of its $3.8 billion of appropriations debt, DiMella said.

"Market access for Puerto Rico is what we worry about," he said. "The door won't close but will get narrower, and there will be pressure on yields to widen."

TOURISM PROJECTS

Fortuno is aiming to raise $4.5 billion for investment in a dozen private-public projects by 2013.

A pending deal to sell an operating lease for San Juan's underused international airport to a private consortium includes not just an upfront cash payment of about $1 billion, but also capital improvements meant to jump-start tourism.

The airport deal is meant to ease the way for the high-end tourists Puerto Rico hopes will fill new luxury hotels being built in San Juan, Dorado and Rio Grande.

Those deals will also help pay down debt. The airport deal will cut transport debt by $900 million, officials have said.

Fortuno's administration is making many of the right moves, according to Ihlefeld, the Thornburg portfolio manager, but Puerto Rico remains a high-profile risk for muni investors.

"I don't know if it's going to be a surprise," he said. "One day it will be in the news and not in a good way."

(Reporting by Michael Connor in Miami; Additional reporting by Reuters in San Juan, Joan Gralla in New York and Karen Pierog in Chicago; Editing by Dan Grebler)

• A Permanent Economic Emergency