SAN JUAN (Reuters) - Puerto Rico will default for the second time in five months, but will pay the bulk of $1 billion due on Jan. 4, including its most senior debt, Governor Alejandro Garcia Padilla said on Wednesday.

Puerto Rico's Governor Alejandro Garcia Padilla delivers his state of the Commonwealth address at the Capitol building in San Juan, Puerto Rico April 30, 2015. REUTERS/Alvin Baez

The Caribbean island’s biggest payment, $328.7 million in general obligation debt, will be paid, the governor told reporters at a press conference in San Juan. More than half of that payment was made by taking revenues from other commonwealth agencies, he added.

A default on general obligation (GO) debt would have been seen as a more serious stumble because those bonds have the strongest legal protections of any of the island’s obligations.

However, it also keeps alive the drama surrounding its deteriorating finances and $70 billion debt load as investors wait for the next shoe to drop.

The default opens the door to potential litigation from affected creditors, while the island must now turn its focus to trying to achieve a consensual debt restructuring with GO holders before its next big payment of $1.9 billion is due in July.

The governor said he is meeting with creditors in early January, though he did not give a specific date.

When asked about a shutdown of key government services, Garcia Padilla told reporters at a press conference: “We have to do all we can to avoid that situation.”

The U.S. Commonwealth, suffering from a near decade-long recession with a 45 percent poverty rate and a shrinking tax base due to people leaving the island, first defaulted in August when it failed to make the full payment on its Public Finance Corp (PFC) bonds.

One creditor source with significant GO holdings said Puerto Rico’s decision to pay GO debt buys it some credibility as debt restructuring talks continue. “I’m glad we can enjoy our holiday, because there’s going to be a lot of heavy lifting to do when we get back,” the source said.

David Tawil, co-founder of hedge fund Maglan Capital, said a default of GO bonds is also probably inevitable in the long-term, but that there is a slim possibility that either Congress will take action or a settlement could be reached with creditors ahead of a default. Either way, he warned that Puerto Rico is still in the very early stages of dealing with its massive fiscal challenge.

“Citizens need to know that necessary infrastructure and services are there and there is not going to be a government shutdown,” Tawil said.

The island will default on a $35.9 million payment due to its Infrastructure Finance Authority (PRIFA). It will also default on $1.4 million due to its Public Finance Corp, but will make payments to most other authorities. The island was facing a bill of about $1 billion had it made all payments.

Padilla said about $163 million of the GO payment came from clawing back revenues from several agencies, including the highway authority, the convention center authority and the island’s busing authority. Garcia Padilla on Dec. 1 granted the U.S. territory power to take revenues from those agencies to keep payments on GO debt current.

“The use of over $100 million in reserved funds to make debt service payments for several of the Commonwealth’s issuers should underscore that the Commonwealth is running out of options to pay its debt,” said Melba Acosta Febo, president of the Government Development Bank.

POTENTIAL LAWSUITS

The announcement now opens the door to litigation from holders of defaulted bonds. One creditor source with exposure at one of the clawed-back agencies told Reuters lawsuits are being considered and could be filed immediately, but creditors have not decided whether the cost of litigation is worthwhile.

Daniel Hanson, an analyst at Height Securities who follows Puerto Rico, said any litigation will focus on Puerto Rico’s credibility. Garcia Padilla has consistently said the island was on the brink of a humanitarian crisis, yet it is able to pay the bulk of its debt and dished out about $120 million in Christmas bonuses this month, Hanson pointed out.

Such questions could also hamper Puerto Rico’s efforts to convince U.S. Congress that it is in desperate need of legislative aid, Hanson said.

The U.S. Treasury has been pushing Congress to allow the island to restructure its debts under U.S. bankruptcy law. A Treasury spokesman said Wednesday that the latest default “demands swift Congressional action” for a restructuring with independent oversight.

The House is expected to hold a Jan. 5 hearing on Puerto Rico’s financial problems.

The source with significant GO exposure acknowledged that clawing back certain debt to pay GO holders is legal, but said a lawsuit would likely focus on whether Puerto Rico met the legal requirements needed to exercise clawbacks, namely proving it was cash-strapped and had no other choice.

Bond insurer Ambac Financial, which insures about $863 million in PRIFA bonds, on Tuesday wrote a letter to Garcia Padilla challenging whether the clawbacks were used properly under Puerto Rican laws.

General obligation bonds with an 8 percent coupon and maturing in 2035 were slightly higher on Wednesday, traded at an average price of 73 cents on the dollar compared to 71.726 on Tuesday. The average yield fell to 11.501 percent from 11.716.

The island owes about $400 million due February 1, mostly to Puerto Rico Sales Tax Financing Corp, or COFINA. The monies for this payment are already held in reserve, Garcia Padilla said.