Analysis: Investors look to Canada debt in U.S., Europe crises

TORONTO Wed Jul 20, 2011 3:43pm EDT

A Canadian dollar coin, commonly called a ''Loonie'' and an American dollar bill are seen in this staged photo in Toronto, March 17, 2010. REUTERS/Mark Blinch

A Canadian dollar coin, commonly called a ''Loonie'' and an American dollar bill are seen in this staged photo in Toronto, March 17, 2010.

Credit: Reuters/Mark Blinch

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TORONTO (Reuters) - Canada's debt market is seeing an influx of money as crises in Europe and United States send investors elsewhere, but the country's relatively small market means the shift may not be permanent.

With its strong economy, stable debt market and sound banks, Canada has long been a refuge for those looking for somewhere to park their money. But instability in the world's biggest debt markets has made it even more attractive.

Foreigners -- mainly Americans but also increasingly British and Asian investors -- more than doubled their investment in Canadian bonds in May from April, Statistics Canada said on Monday.

This helped boost overall securities purchases to their highest level in a year at C$15.44 billion ($16.08 billion), including C$11.1 billion in bonds, almost all issued by governments and government-owned enterprises.

"There is an effort underway by reserve managers, who have accumulated a lot of dollars over the last five years, to find new ways to diversify," said Dan Katzive, senior currency strategist at Credit Suisse in New York.

The big debate is whether the move into Canadian debt will last, especially as the size of the market deters investors.

Michael Gregory, senior economist at BMO Capital Markets in Toronto, believes once newcomers get a taste of the market and accept some of its liquidity constraints, they'll start to look more closely at other Canadian debt options.

"It's almost like you're seeing a cascading thing, from initially investors moving into the government bond space, and as they get comfortable they begin to move along the credit spectrum, moving into agencies like CMBs (Canada mortgage bonds), moving into provincials, then eventually gravitating into corporate bonds," Gregory said.

"I believe we are seeing a permanent shift and portfolio preference toward Canada, period."

Both Canada and the United States have top-notch AAA credit ratings, but the U.S. rating is under pressure on the failure of lawmakers there to come up with a deficit-reduction plan.

NOT ENOUGH TO GO AROUND

But no one is suggesting Canada can even begin to replace debtors like the United States among investors, who view U.S. Treasuries as a staple in their portfolios no matter how close that country comes to debt ceilings or default.

Canada, a leader among G7 peers for taming budget deficits -- at least until the recession -- simply does not have enough debt to satisfy the needs of interested buyers.

"It's not big enough," said Bank of America Merrill Lynch analyst Sheryl King, dismissing the notion that Canada could be the next big debt player. "We've only got an C$800 billion dollar market, so even mild diversification out of U.S. or Europe would put upward pressure on Canadian bond prices."

Canada's bond market is triple the size of the next big alternative, Australia, but still less liquid than investors would like. The amount of publicly held marketable debt in the United States is about $9 trillion -- 11 times that of Canada.

"We might be a flight to safety but we're not a flight to liquidity, quite the opposite," said King. "You can get the money in but you can't necessarily get it out."

Mark Chandler, head of Canadian fixed income and currency strategy at RBC Capital Markets, believes Canada's reputation as a "boring, safe haven" has won some permanent buyers, in contrast to the surge it sometimes saw in the past when spreads with U.S. Treasuries widened.

"What's happened now, and what we've seen over the past few months is symptomatic of it, is people are entering Canada not with expectations of 'Oh there are some very juicy returns, I'll make a quick killing and away I go', but a decent portion of Canadian dollar assets is there as some sort of insurance," Chandler said.

"Where it slows down for Canada is when things start looking better abroad."

In the late 1980s and early 1990s, many foreigners invested in Canada because of rich yield premiums above U.S. Treasuries. Canadian short-term rates are still higher because the Bank of Canada has begun tightening monetary policy while the U.S. Federal Reserve has kept rates low at emergency levels.

But further out the curve there is little difference, partly because of foreign buying and a positive view of Canada's long-term fundamentals.

Canada's 10-year bond yields 2.93 percent, while U.S. 10-year Treasuries yield 2.92.

Katzive said foreign flows, driven by a positive view of Canada's prospects, are set to continue.

"Canada is one of the deeper reserve currencies in terms of the bond market. After the U.S., euro, the yen, liquidity starts to drop pretty quickly and Canada tests relatively high in terms of liquidity among alternatives," he said.

(Additional reporting by Louise Egan in Ottawa; editing by Janet Guttsman)

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