(Adds quote from Moody's, bondholder, updates prices)
By Megan Davies
NEW YORK, Sept 2 (Reuters) - Puerto Rico's electric power utility PREPA has agreed with a bondholder group to reduce its $9 billion debt, a significant step towards restructuring the obligations of the U.S. territory, although the deal will be classed by credit ratings agencies as another default from the indebted island.
Under the deal with the so-called ad hoc group representing about 35 percent of its bondholders, those creditors would swap their bonds for new notes, receiving 85 percent of their existing bond claims, according to a statement from the utility.
Credit rating agency Standard & Poor's said the deal was a distressed exchange and "we would consider PREPA to be in default if this restructuring were to occur" and would lower the ratings on its outstanding debt to a D. S&P currently rates PREPA's bonds at CC.
Moody's said the announcement of a deal meant "a default in the form of a distressed exchange transaction is likely this year." Moody's currently rates the bonds Caa3.
The deal was reached late Tuesday night according to sources. Bondholders holding around $2.9 billion have agreed to swap and the group believes the deal will also attract the retail base which represents $3.1 billion, according to a source familiar with the situation.
Puerto Rico's Governor, Alejandro Garcia Padilla said Wednesday the deal was the next step towards PREPA getting the liquidity to invest in its infrastructure, which would create jobs and spur economic growth.
"I hope this process - and its outcome - will further confirm our commitment to work collaboratively with our creditors to find satisfactory solutions for them and the people of Puerto Rico and their families."
PREPA bonds rallied broadly on the deal, with bonds due 2028 at around 68 cents, versus 56 cents on Tuesday and bonds due 2019 at around 100 cents from 98 cents on Monday.
"The workout was much better than we expected," said Ben Eiler, managing partner at First Southern Securities in Puerto Rico, which holds PREPA debt. Eiler said that a 15 percent cut was acceptable.
Finding a solution for PREPA had been seen as a critical test for the U.S. territory to overcome political and other challenges in fixing other indebted entities.
In June, Garcia Padilla said that the U.S. territory could not afford to pay its debts, totaling $72 billion, adding that all Puerto Rico's bonds were now negotiable.
On Aug. 1 Puerto Rico defaulted on its debt by paying only a fraction of what was due on its Public Finance Corp bonds.
It marked the most notable default in the U.S. $3.7 trillion municipal bonds market since Detroit defaulted on $1.45 billion of insured pension bonds before filing for bankruptcy in 2013.
In its statement on Wednesday, PREPA said it will continue negotiating with its bond insurers as well as those lenders who were not party to the deal.
Under the accord reached with the ad hoc group, bondholders will have the option to receive securitization bonds that will pay cash interest at a rate of 4 percent to 4.75 percent, depending on the rating obtained, or convertible capital appreciation securitization bonds that will accrete interest at a rate of 4.5 percent to 5.5 percent for the first five years.
In either case, the bonds cannot be called for 10 years afterwards which then can be called at par, according to a term sheet released by PREPA. The securitization bonds will receive interest in cash or capital appreciation only for the first five years following issuance, the term sheet said. The scheduled maturity is in 2043.
Terms of the deal states that the bonds must receive an investment grade rating from at least one of the three major ratings agencies.
"(The deal) provides PREPA with a fresh start and financial flexibility, with bondholders providing meaningful sacrifices to make that happen," said Stephen Spencer of Houlihan Lokey, the PREPA Bondholder Group's financial advisor, in a statement.
The deal, assuming participation from 75 percent of uninsured bondholders outside the group, is forecast to reduce PREPA's total debt principal by $670 million and save more than $700 million in principal and interest payments over the next five years, said PREPA's Chief Restructuring Officer Lisa Donahue in a statement.
Under a forbearance agreement with creditors, PREPA was safe from lawsuits as the two sides negotiated. Creditors could have terminated the deal if a restructuring pact was not reached by midnight on Tuesday, Sept. 1.
PREPA said on Wednesday it agreed to an extension of the forbearance agreements through Sept. 18, 2015 with all the creditors party to the original deal except bond insurer National Public Finance Guarantee Corporation, a unit of MBIA Assured Guaranty, another bond insurer, was also party to the forbearance deal.
Shares of Assured Guaranty rose 5 percent while MBIA rose 14 percent. Puerto Rico banks were also sharply higher such as Popular Inc, up 6 percent, and OFG Bancorp up 22 percent.
Reporting by Megan Davies; additional reporting by Jessica DiNapoli; Editing by W Simon and Diane Craft