Sept. 16 (Bloomberg) -- Canada's two-year government note yield rose the most in more than three months as investors speculated the Federal Reserve was discussing a loan to American International Group Inc., the insurer facing a cash shortage.

Yields on two-year securities, more sensitive to changes in monetary policy, climbed faster than 10-year notes, which are tied to expectations for inflation. The two-year yield fell the most in 11 years yesterday on concern AIG might be forced into bankruptcy after the U.S. Treasury and central bank didn't participate in a bailout for Lehman Brothers Holdings, Inc., the fourth-largest U.S. investment bank.

``The fundamental backdrop is AIG's pervasiveness,'' said James Dutkiewicz, lead portfolio manager of C$5 billion ($4.67 billion) in fixed-income assets at CI Mutual Funds in Toronto. The plan helps Canada's financial markets because ``all the Canadian insurance companies and all the Canadian banks are going to have exposure to AIG.''

The yield on the two-year note rose 15 basis points, or 0.15 percentage point, to 2.63 percent at 4:11 p.m. in Toronto. It has fallen 45 basis points in the past two months. The price of the 2.75 percent security maturing in December 2010 fell 32 cents to C$100.28.

10-Year Yield

The 10-year government note's yield climbed 9 basis points to 3.48 percent. The price of the 4.25 percent note maturing in June 2018 declined 78 cents to C$106.34. The yield earlier reached 3.34 percent, the lowest since at least 1989, when Bloomberg began collecting the data.

Dutkiewicz said his firm had been buying government debt in the past week when prices had fallen. ``Bonds should be bought on weakness,'' he said.

The 10-year bond yielded 85 basis points more than the two- year security, down from 91 basis points yesterday.

The yield advantage of the 10-year U.S. Treasury note compared with similar-maturity Canadian government bonds was 7 basis points, down from 39 basis points on June 16. The Canadian 10-year bond yielded 36 basis points more than its U.S. counterpart on Jan. 22.

The two-year bond's yield will increase to 3.15 percent by year-end, while the 10-year bond's yield will gain to 3.83 percent, according to the median forecasts of economists surveyed by Bloomberg.

Canadian government bonds have returned 5.3 percent in 2008, according to Merrill Lynch & Co. index statistics. U.S. Treasuries have returned 6.1 percent this year.

Canada's dollar, dubbed the loonie because of the aquatic bird on the one-dollar coin, rose 0.2 percent to C$1.0687 per U.S. dollar, from C$1.0706 yesterday. One Canadian dollar buys 93.58 U.S. cents.

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: September 16, 2008 16:20 EDT