By Brendan A. McGrail and Matt Robinson

March 8 (Bloomberg) — Puerto Rico, the U.S. territory that reduced its budget deficit by more than a third since 2009, is selling $250 million of debt after its first credit-rating upgrade since Standard & Poor’s began coverage in 1986.

S&P yesterday boosted the commonwealth’s general-obligation rating one level to BBB, the second-lowest of 10 investment grades, because of improved tax collections. Puerto Rico is graded BBB+ by Fitch Ratings, one level above S&P, and A3 by Moody’s Investors Service, two levels higher.

Puerto Rico is more reliable because Governor Luis Fortuno, who took office in January 2009, has cut spending and controlled debt, said Richard Larkin, director of credit analysis at Herbert J. Sims & Co. in Iselin, New Jersey, which manages about $1 billion.

“I’m not surprised about the upgrade,” Larkin said in a telephone interview. “What he’s done could be a model for other governors.”

The commonwealth reduced its budget gap from $3.3 billion in 2009, larger in proportion to revenue than any state, to a projected $1 billion this year. Fortuno has implementing austerity measures, including renegotiating contracts and cutting payroll spending 17 percent by firing 12,600 workers and eliminating more than 7,000 other positions.

He also sought to spur economic activity by passing a tax overhaul in February that lowers business levies an average of 30 percent and individual assessments by 50 percent over six years, as long as growth, revenue and spending targets are met.

To pay for the measure, the territory imposed a temporary 4 percent tax on foreign manufacturers and strengthened laws to curb evasion.

Added Flexibility

“Collections from the recently enacted excise tax will provide the commonwealth with additional flexibility to continue to narrow the budget gap and achieve structurally balanced budgets in the next two years,” Horacio Aldrete-Sanchez, an S&P analyst, wrote in a report yesterday.

Puerto Rico last sold general obligations Feb. 10, with 29- year notes priced to yield 6.4 percent, or 147 basis points above top-rated debt, according to a Bloomberg Valuation index.

The bonds traded yesterday at an average yield of 6.07 percent, according to Municipal Securities Rulemaking Board data. That’s about 124 basis points above the BVAL index.

Bonds of Puerto Rico, a self-governing commonwealth ceded to the U.S. in 1898 after the Spanish-American War, offer investors an exemption from any state’s income tax, unlike most municipal debt.

Credit Concerns

While the exemption is a “tremendous” help to spur investor interest, the island still has credit concerns, said Howard Cure, director of municipal research for Evercore Wealth Management LLC in New York, with about $2.6 billion under management.

“Puerto Rico has made progress, but its unfunded pension is a huge potential burden,” Cure said.

As of June 30, 2009, promised benefits not covered by assets of the Employees Retirement System, Teachers Retirement System and the Judiciary Retirement System were $17.1 billion, $6.6 billion and $273 million, respectively, according to a Feb. 25 Moody’s report.

Proceeds from this week’s sale will refinance existing debt, including advances on Puerto Rico’s line of credit with the Government Development Bank, the government’s fiscal agent, according to preliminary offering documents.

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