The Commonwealth of Puerto Rico expected tomorrow to offer $588 million of public improvement bonds and to tap the derivatives markets in a refunding of bonds issued in 1986 through 1990.

Officials at the Government Development Bank of Puerto Rico, which acts as fiscal agent and adviser for the commonwealth, said a portion of the loan may be offered via auction rate notes and yield curve rate notes - a derivative used by senior manager Morgan Stanley & Co.

According to the commonwealth's preliminary official statement, the bonds to be refunded range from $28.6 million of general obligation bonds sold June 30, 1988, maturing in 2007, and priced to yield 8%; to $203 million of GOs sold in August 1990, maturing in 2020, and priced to yield 7.70%.

Although Puerto Rico will pay from $103 to $101.50 per $100 face value to call the bonds, the current performance of the commonwealth's offerings suggests a significant savings.

On Aug. 5, Morgan Stanley won an offering of $310 million Puerto Rico GOs, marking the commonwealth's first competitive bond sale since 1974.

Morgan Stanley won those bonds with a true interest cost of 5.9703%.

"Their aggressive pricing of that deal was a large part of our decision to use Morgan on this deal," said Jose Pagan, executive vice president of the government development bank. "We were very pleased with the results of that transaction."

Jose M. Berrocal, president of the development bank, said Morgan was able to Price the deal so competitively partly because of its successful marketing of $50 million of the $310 million in the secondary market.

This offering marks Puerto Rico's first use of inverse floaters in the primary market sale of GO debt, Mr. Berrocal said.

Inverse floaters are comprised of two equal variable-rate portions - in this case the auction rate notes and yield curve notes - that make up one guaranteed fixed-rate payment for the issuer, according to William Blais, Morgan Stanley,s senior investment banker for the deal.

The auction rate notes are short-term investments that will be repriced every fifth Thursday through a dutch auction. If the results of the auction produce a rate lower then the issuer's guaranteed fixed rate, the difference is given to investors of the other half of the deal - the yield curve notes.

However. investing in the yield curve notes is not without risks. The dutch auction could produce a high rate, which cuts into the yield and in an extreme case would lower the yield to zero.

The preliminary official statement also says that investors may wish to link certain maturities of the auction rate and yield curve rate notes.

Linkage and separation of those links is permitted at any time except for the closed period that would include the three days before and through the auction day.

"Typically, yield curve notes are bought as a long-term, leveraged portion of a portfolio." said John Straus, sales manager at Morgan Stanley. "The auction rate notes would be more a part of an investor's short-term portfollo.'

Mr. Straus said linkage of the two securities would increase the securities' liquidity, in a more stable and bullish market.

Market participants had speculated last week that the refunding could reach as much as $950 million. But officials at the development bank and those involved in pricing the deal said the current volatility of the tax-exempt market should limit the refunding. "I don't foresee the offering growing any more than the original size," Mr. Berrocal said. "At present, the refunding would save the commonwealth 8%."

Mr. Berrocal said that under commonwealth law, a savings of 5% must be realized before Puerto Rico's bonds can be refunded.

"Now is a perfect time for us to refund the bonds." he added.

"We are reducing the amount of debt service and increasing our general fund balance significantly," Mr. Berrocal explained. "In the last four weeks, through the competitive sale two weeks ago, and this refunding. we will have saved the commonwealth over $45 million - or 1% of our annual budget."

"Andrew Rowley, managing director and manager of the syndicate desk at Morgan Stanley, said the size of the offering would have been increased if market conditions had continued to improve.

"The volatility of the municipal market right now has made it appear as if the offering will remain at $588 million," Mr. Rowley said.

Mr. Pagan said the commonwealth had already received confirmation from the Financial Securities Assurance Corp. that $80 million of the loan was eligible for insurance and an additional portion of the loan "would likely receive some form of insurance."

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