Puerto Rico faces a potential credit rating downgrade from Moody’s Investors Service as it heads to market with its first new-money general obligation bond issuance in more than two years.

Moody’s on Tuesday placed $28 billion of outstanding Puerto Rico debt on watchlist for possible downgrade as higher retirement fund contributions could place stress on the commonwealth’s operating budget.

Moody’s rates Puerto Rico’s $9.2 billion of outstanding GO debt A3. The rating action affects a combined $28 billion of outstanding debt that is linked to the commonwealth’s credit.

The government plans to sell $295 million of new-money GO bonds and $900 million of tax and revenue anticipation notes by June 30.

Preliminary actuarial valuations as of June 30, 2010 indicate that Puerto Rico’s employees retirement system faces an unfunded pension liability of $17.8 billion and has a funding level of 8.5%, according to Moody’s. Earlier calculations showed an unfunded obligation of $17.09 billion and a funding ratio of 9.8%, as of June 30, 2009.

Including the smaller teachers retirement system and judiciary retirement system, Puerto Rico’s total unfunded liability is $15.1 billion and its total funding ratio is 13.5%, according to preliminary actuarial valuations from June 30, 2010.

To help repair the pension fund, Gov. Luis Fortuño last month proposed boosting the government’s annual retirement contribution by $48 million in fiscal 2012 and increasing it each year during the next decade.

In addition, the administration plans to inject $162.5 million into the retirement system, with the pension fund using that cash infusion to buy capital appreciation bonds from a potential sales-tax bond deal, said Juan Carlos Batlle, president of the Government Development Bank for Puerto Rico, the commonwealth’s fiscal adviser. The capital appreciation bonds should generate $1.2 billion for the fund over 40 years, he added.

Moody’s concern is that these actions will help strengthen the pension fund at the potential expense of Puerto Rico’s operating budget.

“The watchlist action reflects the deeply underfunded nature of the commonwealth’s retirement system, and the risk that actions that significantly improve the funding ratio of the system may have such a significant cost to the commonwealth that the general fund would be strained to a point not consistent with the current A3 rating,” Moody’s analyst Emily Raimes wrote in a report. “The conclusion of the review could result in a rating change of one or more notches.”

Moody’s plans to complete its review of the credit within 90 days.

Batlle said the GDB will meet with Moody’s within the next two to three weeks to explain in detail the pension changes and Fortuño’s proposed budget. The governor’s retirement initiatives require legislative approval. The administration has yet to announce other pension reforms, such as increasing the retirement age.

“The governor’s recent proposal was probably not as aggressive as investors would have liked to have seen and that’s one of the things that Moody’s picked up on, but I think that’s a shared concern among all investors,” said Joe Rosenblum, senior vice president and head of municipal credit research at Alliance Bernstein.

New York-based Alliance Bernstein holds $200 million of Puerto Rico GOs and a small amount of Puerto Rico Highway and Transportation Authority debt, along with other Puerto Rico credits, according to Rosenblum.

Puerto Rico’s pension challenges have been well known. Moody’s revised Puerto Rico’s outlook to negative from stable in August due to the unfunded liability and low funding levels.

A downgrade from Moody’s would place its rating more in line with the other credit rating agencies. Fitch Ratings and Standard & Poor’s have ratings of BBB-plus and BBB for the commonwealth.

Rosenblum said Puerto Rico bonds already had been trading at a lower price level than a A3 rating would warrant.

“They haven’t been trading at the Moody’s level, they’ve been trading differently,” he said.

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