Municipal debt from Puerto Rico is poised for its worst year since at least 2000 as demand for state and local securities wanes with yields at two-year highs.

Bonds of Puerto Rico and its localities have lost 14.9 percent this year through Aug. 28, about three times more than the rest of the $3.7 trillion municipal market, according to Standard & Poor’s data. The commonwealth’s borrowings haven’t had an annual loss this steep since at least 2000.

Investors demand 2.76 percentage points of additional yield to buy 30-year Puerto Rico general-obligation bonds rather than top-rated munis, the most since January, data compiled by Bloomberg show. The island’s general-obligation debt is rated one level above junk amid recurring budget deficits and a pension system that has a lower funding level than any U.S. state.

Individual investors, who own about 70 percent of the municipal market, are “spooked” by the drop in prices on Puerto Rico bonds and are selling, said Matt Dalton, who manages $1.6 billion of munis at Belle Haven Investments Inc. in White Plains, New York.

“Individuals are running scared on Puerto Rico right now,” he said. The commonwealth’s returns may worsen “before it really finds a bottom; There’s a good chance that it will be the underperformer for 2013.”

Puerto Rico’s population is 3.7 million. Its debt is tax-exempt in all U.S. states, which allows state-specific muni mutual funds to buy the securities. Investors have pulled $21.4 billion of cash from U.S. muni mutual funds in the 13 weeks through Aug. 21, the most since 2011, Lipper US Fund Flows data show.

Yields Climb

Puerto Rico general obligations maturing in July 2041 traded today at an average yield of 8.03 percent, the highest since they were sold in March 2012, Bloomberg data show.

As investors bet a growing economy will lead the Federal Reserve to curtail its bond buying, the muni market has lost 4.98 percent this year, according to S&P data.

Losses on Puerto Rico accelerated after Barron’s published an article in its Aug. 26 issue on the commonwealth’s fiscal challenges, saying the bonds may suffer. The island’s debt may drop even further as the commonwealth plans to borrow in the next couple of months, Dalton said.

The commonwealth is set to refinance $600 million of general obligations in September, and the Puerto Rico Highways & Transportation Authority will issue $750 million to $1 billion of revenue bonds within about 30 days of the general-obligation sale, Jose Pagan, interim president of the Government Development Bank for Puerto Rico, said last month.

The commonwealth had about $70 billion of public-sector debt as of June 30, according to the Development Bank, which handles the island’s capital-market transactions.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net