Canada’s reluctance to raise interest rates much beyond those in the U.S. is an opportunity for U.S. investors to profit by buying Canadian bonds, according to Pacific Investment Management Co., the world’s largest manager of bond funds.

The difference in yields between Canadian and U.S. two-year notes widened Tuesday to the most since January 2004, as investors increased bets that Canada’s key rate will diverge from the U.S. rate. That may not happen if quantitative easing in the U.S. and growing demand for commodities bolsters the Canadian dollar and damps demand for the nation’s exports, prompting Bank of Canada Governor Mark Carney to hold off from rate increases, said Edward Devlin, a money manager at Pimco.

“If rates don’t change in the U.S. and Canada, and you sold your U.S. two-year note and bought a Canadian two-year note, you are tripling” yield, said Devlin, who heads Pimco’s Canadian portfolio management team. “With the interest rate differential where it is now, we think that is a relatively attractive place to invest especially for a U.S.-based investor.”

Mr. Carney left the benchmark target rate at 1% last month, following three consecutive increases to gauge the global recovery and avoiding a divergence with the Federal Reserve, which has locked its benchmark rate in a range of zero to 0.25% since December 2008. Mr. Carney said in a Sept. 24 interview on CNBC that “there are limits to the divergence that there can be between Canada and the United States.”

Elsewhere in credit markets, the extra yield investors demand to hold the debt of Canada’s corporations rather than its federal government, was unchanged yesterday at 135 basis points, or 1.35%age points. Spreads reached 134 basis points Nov. 16, the narrowest gap since March.

Breakeven Rates

In provincial bond markets, relative yields were unchanged at 53 basis points. They reached 51 basis points on Nov. 16, the tightest spreads since April.

Canadian 10-year breakeven rates, which measure the difference in yield between inflation-linked and cash bonds and gauges price expectations, jumped to 2.275% Tuesday, its highest level since May. Statistics Canada Tuesday said inflation in the country advanced at the fastest pace in two years, accelerating to 2.4% in October after a 1.9% gain in September.

Triple the Yield

“With a strong currency, it’s very difficult for the Bank of Canada to get too far ahead of the” Fed, said Devlin. In addition to the extra yield on Canadian bonds, investors have “the benefit of the dollar if you think it’s going up.”

Canada’s currency has gained 19% against the U.S. dollar since the start of 2009. The Canadian currency fell 0.6% to CUS$1.0246 per U.S. dollar yesterday in Toronto from CUS$1.0187 the prior day. One Canadian dollar buys 97.78 U.S. cents.

Devlin declined to comment on specific Pimco trades. The fund manages over US$8 billion in assets on behalf of Canadian clients, he said. Pimco, a unit of the Munich-based insurer Allianz SE, managed US$1.236 trillion of assets as of September.

Canadian two-year notes were yielding 1.65% yesterday, compared with 0.445% in the U.S, widening the spread to 121 basis points, the highest since Jan. 14, 2004. The spread has averaged 83 basis points this year. One basis point is 0.01%age point.

Canadian 10-year notes, yielding 3.09% Tuesday, are trading 33 basis points above U.S. notes. The average spread between Canadian and U.S. 10-year notes has been 4.8 basis points this year.

Canadian government bonds have returned 7.3% this year, and are headed for an 8.8% annual return, the most since 2008, when they returned 12%, Bank of America Merrill Lynch data show. Global government bonds have returned 5.7% this year, and U.S. Treasuries have generated an 8.6% gain.

Canadian bonds also will benefit from the country’s relatively better fiscal position at a time of heightened sovereign credit risk, while investors are less concerned about inflation in Canada since the country’s central bank refrained from printing money, Devlin said. That will sustain demand and reduce volatility of longer-dated bonds, he said.

“People who look to quality come to Canada because of sovereign debt issues,” Devlin said, adding he expects real rates of return will stay relatively low and inflation expectations will remain anchored so “the backend of Canada’s yield curve stays relatively less volatile than the back end of the U.S. yield curve.”

In an article published Nov. 19 on Pimco’s website, Devlin said the Newport Beach, California-based firm is “long-term bullish” on the Canadian dollar, though there could be volatility because of policy-driven “distortions” coming primarily from the U.S. and China. Devlin cited risks associated with any potential drop in commodity prices, the effects of a higher Canadian dollar fuelled by monetary and currency policies in China and the U.S., and sovereign credit problems in other countries.