Puerto Rico may have its credit rating cut to junk in the fiscal year beginning July 1 as the commonwealth struggles with a shrinking economy, says Peter Hayes, head of municipal debt at New York-based BlackRock Inc. (BLK)

The self-governing Caribbean territory is ranked one step above speculative grade by the three major credit companies. Should it fail to meet its projections for tax revenue and economic growth, one of the firms may lower its rating as soon as mid-2014, Hayes said today at a media presentation in New York. He helps oversee $108 billion of munis, including Puerto Rico debt, for the world’s largest money manager.

“A downgrade will mean that there will be some more forced sellers,” at which point BlackRock will look to buy, Hayes said. “Most markets overreact and we suspect that it will happen here as well.”

Puerto Rico’s fiscal stability and the outlook for its debt has significance for the $3.7 trillion municipal-bond market because 77 percent of U.S. muni mutual funds hold its bonds, according to Morningstar Inc. (MORN) The securities are tax-exempt nationwide.

The commonwealth and its agencies had $70 billion of debt as of June 30, according to Puerto Rico’s Government Development Bank, which handles capital-market transactions for the territory.

An index measuring the economy of the island of 3.7 million people fell 5.4 percent in August from a year earlier, the biggest drop since 2010, according to the bank. Betsy Nazario, a spokeswoman for the bank, didn’t immediately respond to an e-mail seeking comment on the prospect of a rating reduction.

Rally Extended

Even with Hayes’s outlook, Puerto Rico debt is extending its biggest rally in almost a month.

Government Development Bank officials helped trigger the gains with an investor presentation on Oct. 15. They said that while they plan to sell as much as $1.2 billion of sales-tax bonds by Dec. 31 to balance budgets, the commonwealth has enough funds to hold off on issuance through June 30 if borrowing costs are too high.

Commonwealth general obligations maturing in July 2041 traded today with an average yield of 8.3 percent, the lowest since Sept. 27, data compiled by Bloomberg show. The yield spread above benchmark munis also shrank to the lowest in almost three weeks.

Puerto Rico debt gained about 0.6 percent yesterday, the biggest one-day advance since Sept. 19, according to Standard & Poor’s data. The securities have still lost 21.1 percent this year through Oct. 16, the worst performance since at least 1999 and more than six times the declines in the broader muni market.

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 atsmerelman@bloomberg.net