Puerto Rico bonds offer triple tax-exemption and high yields, but investors should limit their exposure to the commonwealth's debt, advised Alan Schankel, a managing director at Janney Capital Markets.

In a report, he highlighted the commonwealth's massive debt, underfunded pension liabilities and resistance to recovery as areas of concern.

"The pace of debt growth exceeds that of economic growth, an unsustainable proposition," Schankel said.

Puerto Rico and its many issuers, including the Government Development Bank, the Sales Tax Finance Corp., and the Electric Power Authority, have more than $60 billion of debt.

That amount includes about $30 billion of the commonwealth's tax-backed debt outstanding, in addition to major revenue debt.

"These are huge debt levels, considering the island population is just under four million," Schankel said.

Many of Puerto Rico's issuers have dedicated revenue streams, but the creditworthiness of most is intertwined with the island's fiscal health.

Schankel explained that peripheral tax revenues, which support certain issues, are subject to clawback under the commonwealth's constitution, which provides that certain revenues used to support various bond issues are available to be applied first to the payment of general obligation debt, if needed.

The island's economy has been sluggish and slow to recover from the recession, only recently showing signs of improvement.

Earlier this month, the GDB reported that the island's economy had made improvements for the fifth consecutive month, with its economic activity index for April 2012 showing a 0.1% increase from last year.

Schankel noted positive results from recent reforms, but said that economic growth and fiscal stability remain elusive.

"Employment growth is anemic," he said. "Continued public-sector job cuts, necessary for fiscal improvement, will add to the soft employment picture."

The commonwealth also has an ongoing budget deficit, with a $1 billion shortfall estimated for 2013. Some good news is that the deficit has slightly narrowed since 2009, when it was $2.9 billion.

Adding to its financial stress are Puerto Rico's large amounts of unfunded pension liabilities, which have recently prompted Standard & Poor's to revise the outlook on $2.9 billion of the Employees Retirement System's senior funding bonds to negative.

Based on current funding and disbursement rates, Puerto Rico's two major pension systems, the Employees Retirement System and the Teachers System, are expected to be depleted after 2020 and 2022, respectively.

Despite its financial problems, Puerto Rico's current GO credit spreads, with yields about 200 basis points above the triple-A benchmarks, do not reflect bondholder risk, Schankel said.

"Investors are cautioned to limit portfolio exposure to Puerto Rico bonds, with 10% concentration a recommended ceiling for risk-tolerant investors, and much lower levels appropriate for most," he advised.

While he does not anticipate any defaults in the near term, downgrades are more likely than upgrades in the near future.