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By Hugh Bronstein

BOGOTA (Reuters) - Investors are buying Colombian
bonds based on expectations that the country will soon regain
its investment credit grade rating, but the government faces a
tough reform agenda that could drag the process out.

President Juan Manuel Santos, inaugurated on Aug. 7, is
sending bills to Congress aimed at reining in Colombia's
central government fiscal deficit, estimated at 4.4 percent of
gross domestic product this year, up from 4.2 percent in 2009.

Colombian bond spreads, which measure risk as compared with
U.S. Treasuries, have narrowed to the same range of more
fiscally sound investment-grade countries like Peru and Brazil,
indicating that investors have already priced in an upgrade.

"The market is assuming this is going to happen sooner than
it will," said Bret Rosen, senior credit strategist for Latin
America at Standard Chartered.

"Colombia ... is already trading as an investment grade
credit," he added. "But there is an ambitious reform agenda
ahead and the fiscal numbers are not good, so we think there
may be room for disappointment."

Santos is asking Congress to approve a fiscal rule that
would oblige the state to save money and cut debt during boom
times. The goal is to reach fiscal equilibrium by 2014.

He also wants to revamp the public healthcare system to
keep it solvent, move unregistered workers onto the tax rolls,
and centralize the way mining and oil royalties are spent.

Investors have welcomed this reform agenda as the last step
toward an upgrade by credit agencies such as Standard & Poor's,
Moody's, and Fitch, all of which currently rate Colombia one
notch below investment grade.

The rating upgrade would lower government borrowing costs
and make it easier for companies to raise money. This would in
turn spur investment, support economic growth, and help plug
the fiscal hole.

LOOKING FOR VALUE

Colombian global bonds were at 165 basis points over U.S.
Treasuries on Monday, according to JP Morgan's Emerging Markets
Bond Index Plus . Brazil spreads were 204
basis points and Peru's were at 160.

"Colombia's international bonds have already discounted
most of the upgrade, which could come next year if the
government has success in implementing its reforms," said
Camilo Perez, chief economist at Banco de Bogota.

"Local government bonds, particularly on the long end, are
lagging. That's where you should go if you are looking for
value as a possible upgrade approaches," he said.

When Brazil won investment grade in 2008 the country
widened its investor base and smaller Brazilian companies
received an increase in acquisition offers from foreign firms.

On the flipside, capital inflows to Brazil have
dramatically strengthened the local currency. That's a problem
already well known in Colombia, where the peso is near two-year
highs that have exporters, who get paid in U.S. dollars,
howling for relief.

Colombia's credit rating has been mired in junk bond
territory since an economic crisis in 1999 tore its banking
sector apart.

One tax and pension reform bill after another has been
watered down by Congress since then while previous President
Alvaro Uribe was criticized for high spending meant to shore up
his popularity while his government tried, and failed, to
change the constitution to allow him to run for a third term.

But Uribe made the country much safer with his U.S.-backed
crackdown on leftist rebels. As a result investor confidence
improved sparking a mining and oil boom that should help shore
up fiscal accounts.

EYES ON CONGRESS

Fitch has Colombia's long-term foreign currency sovereign
rating at 'BB-plus' with a stable outlook. The next step up
would be to the investment-grade rating of 'BBB-minus', where
Brazil, Peru and Panama are currently scored by the agency.

"Santos has a competent team that is bringing new
initiatives. We will have to see how those initiatives develop,
both in terms of their passage in Congress and their
implementation," said Fitch analyst Erich Arispe.

David Rolley, who co-manages a portfolio of over $25
billion for Loomis Sayles in Boston, said fiscal results from
Santos' reform agenda should start to appear during 2011.

"But there are going to be some headwinds from a very
possible global slowdown," he added. "So I'd be surprised if an
upgrade comes within a year."

Colombian lawmakers have a history of voting against
reforms that would save money by cutting benefits for their
constituents, so there is some uncertainty about how well
Santos' program will fare in Congress.

The hardest bill to get passed appears to be a proposal
that would take control of mining and oil royalties away from
regional authorities. The president wants to use commodities
sector royalties to feed an overseas savings fund and to pay
for infrastructure projects nationwide.

"If this is not approved during his first year in power, it
won't happen," said Liberal party Senator Juan Cristo, who
supports the measure. "Of all the reforms, the royalties bill
will be the toughest because local governors and mayors in in
commodities-producing provinces are against it."

(Additional reporting by Daniel Bases in New York and
Guillermo Parra-Bernal in Sao Paulo)