April 13 (Bloomberg) -- Japanese bond yields may rise from the highest level in five months and approach last year’s peak as the government boosts debt sales to fund extra spending, according to Calyon and UBS Securities Japan Ltd.

Benchmark 10-year yields touched the highest since November last week as Chief Cabinet Secretary Takeo Kawamura said Japan will sell as much as 11 trillion yen ($110 billion) of new bonds to pay for Prime Minister Taro Aso’s third stimulus package since taking office in September. Rising bond yields will make it more expensive for the government to borrow funds to help the economy avoid its worst recession since World War II.

“We may have to brace for explosive increases in bond sales this year,” said Susumu Kato, chief economist in Tokyo at Calyon, the investment banking unit of France’s Credit Agricole SA. “As the environment gets worse, a test of last year’s high level for the 10-year yield may come into sight.”

The 10-year bond yield climbed to as high as 1.49 percent on April 10 from a five-year low of 1.155 percent on Dec. 30, according to data compiled by Bloomberg. The yield closed at 1.45 percent last week at Japan Bond Trading Co. The bond has not traded so far today.

Ten-year yields touched a one-year high of 1.895 percent on June 16 last year on concern quickening inflation would prompt the central bank to raise its benchmark interest rate, then at 0.5 percent.

‘Massive Rise’

Aso unveiled a record 15.4 trillion yen stimulus package on April 10 to help revive the economy. Including financial measures and guarantees, the plan will total 56.8 trillion yen, Aso said at a press conference in Tokyo on April 10. His third package since taking office in September would take total spending to 25 trillion yen.

“Funds required for the new stimulus and shortfalls in tax revenue mean additional bond issuance may reach 13 trillion yen to 18 trillion yen this fiscal year,” said Chotaro Morita, chief strategist at Barclays Capital Japan Ltd. in Tokyo. “The massive rise in supply should have a significant impact on the bond market.”

The spending package will be the largest ever for a single year, surpassing former Prime Minister Keizo Obuchi’s 8.5 trillion yen stimulus during the Asian financial crisis in 1998.

Bank of Japan Deputy Governor Hirohide Yamaguchi said the central bank doesn’t expect interest rates to increase while the economy is in recession.

Avoid Buying

“Long-term interest rates usually rise when people expect the economy will rebound or prices will rise,” Yamaguchi said at a press conference on March 25. “The question is what kind of judgment we should make if long-term rates start to rise while the economy remains in bad shape. We basically don’t expect such situations to arise.”

Bond yields may also increase as the government’s additional spending begins to flow through to the economy, said Akio Yoshino, chief economist in Tokyo at Societe Generale Asset Management (Japan) Co.

“Looking at the proposed measures this time I feel the pump-priming measures may work,” said Yoshino at the unit of the French asset management firm that supervises the equivalent of $338 billion. “Given expectations things will change for the better, the Nikkei 225 Stock Average may rise and the yield on 10-year debt may reach 1.6 percent,” he said.

Debt Supply

Concern about the rising supply of debt comes just as the world’s second-largest economy shows signs of improvement.

The Economy Watchers index, a survey of taxi drivers, hairdressers and others who deal with consumers, climbed to 28.4 last month from 19.4 in February, the second-biggest jump on record and the third straight month of improvement, the Cabinet Office said on April 8.

Machinery orders unexpectedly rose for the first time in five months in February. Orders, an indicator of capital investment in the next three to six months, climbed 1.4 percent in February from the previous month, the Cabinet Office said April 9 in Tokyo.

“We are starting to see signs the economy is bottoming out,” said Tatsushi Shikano, a senior economist at Mitsubishi UFJ Securities Co. in Tokyo. “The yield of the 10-year bond may rise toward 1.7 percent.”

Still, some analysts say bond yields are close to their peak as policy makers may act to restrain their advance.

Becoming Attractive

“Once the fog about supply conditions are removed, the yield on the 10-year bond should come back to the 1.1 percent to 1.4 percent range,” said Kazuya Seki, deputy general manager of the treasury department at the banking unit of Chuo Mitsui Trust & Banking Co. in Tokyo. “The yield is now gradually approaching attractive levels where we may be able to start buying bonds.”

The 10-year yield averaged 1.48 percent during the 10 years after the Bank of Japan cut its benchmark rate to zero in February 1999.

Since the collapse of Lehman Brothers Holdings Inc. in September, the BOJ has lowered its policy target rate by a total of 0.4 percentage point to 0.1 percent and increased outright purchases of government bonds by 50 percent to 1.8 trillion yen a month.

“If the benchmark yield approaches 2 percent, pressure on the BOJ to do more to contain surging yields may emerge,” Barclays’ Morita said.

To contact the reporter on this story: Yasuhiko Seki in Tokyo at Yseki5@bloomberg.net; Nobuyuki Akama in Tokyo at akam@bloomberg.net.

Last Updated: April 12, 2009 22:46 EDT