TORONTO, Sept 20 (Reuters) - Global investors are warming up to Canadian bonds and their newly attractive yields, saying there is a limit to how much the Bank of Canada can diverge from its peers after its two interest rate hikes this year.
Canada's bonds could still lose ground if the central bank tightens monetary policy more than markets currently expect. But the lure of these bonds for global fund managers may be signaling their underperformance versus those of other countries over the last few months will soon fade.
Canada's 10-year yield, which moves inversely to price, has surged nearly three-quarters of 1 percent since June to 3-year highs above 2 percent, even as low inflation and North Korea tensions have weighed on yields of other government bonds like German Bunds and U.S. Treasuries.
"I certainly think longer maturity (Canadian) rates offer good value now, especially as a spread versus other markets such as the UK and Germany," said James Athey, senior investment manager at Aberdeen Asset Management in London, which has 583 billion pounds ($791.8 billion) of assets under management.
Canada's benchmark 10-year debt is yielding 1.7 percentage points more than the German equivalent, the biggest difference since August 1995, while there is also a yield advantage when owning shorter-dated Canadian bonds over U.S. Treasuries.
That additional yield also translates into better returns for Canada's corporate bonds. It prompted Geoff Castle, a portfolio manager at PenderFund Capital Management, to switch some holdings from the United States to Canada, such as the purchase of air navigation service operator NAV Canada's April 2019 bond, which is yielding around 2.10 percent.
We are "picking up a higher coupon with a pretty good credit" in a Canadian name, Castle said.
The shift to a positive yield spread came as the Bank of Canada raised rates twice in the last three months as the domestic economy accelerated.
Money markets are pricing in three more hikes from the Bank of Canada by the end of 2018, outpacing expectations for the Federal Reserve which is the only other major central bank to have raised rates this year.
But a faster pace of rate hikes tends to support a country's currency, which can weigh on exporters as their goods become more expensive to holders of other currencies.
There is therefore a view among investors that "the Canadian economy can't be divorced from its trading partners," said Scott Lampard, head of global markets at HSBC Bank Canada. "We have seen better buying at these levels" from domestic and international clients.
That outlook is reflected in government data showing foreign investment in Canadian bonds hit a record C$23.8 billion ($19.42 billion) in July, although much of that was in foreign currency denominated bonds.
"Yields are now approaching a level that, while still susceptible to further rate hikes by the Bank of Canada, are significantly more appropriately valued than six months ago," said Sunil Shah, a portfolio manager at Aviva Investors, which manages $288 billion in fixed income assets globally.
Record high borrowing by Canadian consumers, the renegotiation of the North American Free Trade Agreement and a stronger Canadian dollar will deter "runaway" rate hikes, Shah said.
Bank of Canada Deputy Governor Timothy Lane said on Monday that the currency's strength will be a factor in future rate decisions, which could signal a more gradual approach to tightening.
"It is unlikely the Bank of Canada will continue to diverge from other major central banks," said Angus Sippe, multi-asset fund manager at Schroders, which has $85 billion of assets under management.
($1 = 1.2258 Canadian dollars)
($1 = 0.7363 pounds)
(Reporting by Fergal Smith; Editing by Meredith Mazzilli)