By Theresa Barraclough Nov. 11 (Bloomberg) -- Japanese government bonds rose for a second day, the first back-to-back gain in a month, as yields near the highest level since June attracted investors. Demand for bonds also increased before a Bank of Japan report tomorrow that economists forecast will show producer prices dropped in October. Deflation enhances the value of the fixed payments on debt. Cabinet Office data released today showed machinery orders surged in September. “There are many investors who would buy bonds around the 1.5 percent level,” said Masaru Hamasaki, a strategist at Tokyo-based Toyota Asset Management Co., which oversees the equivalent of $14 billion. Benchmark 10-year bond yields fell four basis points, the most in a month, to 1.43 percent as of 2:02 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price added 0.344 yen to 99.741 yen. The yield touched 1.485 percent yesterday, the highest since June 16. Ten-year bond futures for December delivery rose 0.29 to 137.84 at the Tokyo Stock Exchange. “There should be a lot of demand for bonds with yields around 1.485 percent,” said Kazuhiko Sano, chief strategist in Tokyo at Citigroup Global Markets Japan Inc., one of the primary dealers that are obliged to bid at government debt sales. “The yield curve will probably steepen slightly.” Machinery orders, an indicator of business investment in three to six months, climbed 10.5 percent from August, when they rose 0.5 percent, the Cabinet Office said in Tokyo. Economists in a Bloomberg survey expected an increase of 4.1 percent. Real Yields “Japan has been in deflation, remains in deflation,” Robert Feldman, head of Japan economic research at Morgan Stanley in Tokyo, said in a Bloomberg Radio interview yesterday. Producer prices dropped 6 percent in October after tumbling 7.9 percent the prior month, according to the median estimate of economists in a Bloomberg News survey. Consumer prices fell 2.3 percent in September. So-called real yields, or what investors get after accounting for the cost of living, are near the highest since 1995. Real yields were at 3.74 percent today, near 3.8 percent reached earlier this month, the highest since 1995, according to data compiled by Bloomberg. “The recovery process for Japan in 2010 is expected to be modest and fragile, since domestic economic conditions point towards a possibly extended period of deflation,” David Riley, head of global sovereign ratings at Fitch Ratings, said in a statement released in Tokyo yesterday. Reports yesterday showed the current-account surplus widened and merchant sentiment fell to a five-month low Gains in bonds may be limited as dealers reduce their debt holdings to protect against potential losses at an auction of 2.4 trillion yen ($26.8 billion) in five-year government notes tomorrow. Trading today suggests the finance ministry will set a 0.7 percent coupon on the new securities, up from 0.6 percent at the prior sale last month. Five-Year Auction “We remain bearish Japanese rates going into this week’s five-year sale,” Christian Carrillo, a senior interest-rate strategist at Societe Generale SA in Tokyo, wrote in a note. “Banks likely would run out of cash surpluses ‘in hand’ to invest in JGBs sometime this month and thus will be demanding higher yields at the next five-year auction.” The Oct. 15 sale of five-year notes attracted bids worth 2.17 times the amount on offer, the lowest bid-to-cover ratio since September 2003. Five-year yields are near the highest level in three months on concern the government will increase national debt, already the largest in the industrialized world. Finance Minister Hirohisa Fujii said yesterday Japan’s worsening fiscal health is one reason yields have been rising. The government will try to restrain spending, he said. New Issuance “I’m very concerned” about the recent gain in yields, Fujii told reporters in Tokyo. “Maintaining the trust of investors in the government bond market is our priority.” Fujii reiterated that the government will try to ensure new bond sales don’t exceed 44 trillion yen in the year starting April 1, the amount initially budgeted for the current period. Fitch Ratings would need to review its AA- credit rating on Japan should there be a “material increase” in debt sales above 44 trillion yen next fiscal year, Reuters reported yesterday, citing an interview with Riley. Declining tax revenue in the wake of the country’s worst postwar recession may mean debt sales will climb to a record 50 trillion yen this business year, Vice Finance Minister Yoshihiko Noda said last month. To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net

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