Nov. 17 (Bloomberg) -- Japanese bonds rose, with five-year debt gaining for a third day, after a government report showed that the world's second-largest economy entered its first recession since 2001.

Five-year yields fell toward a seven-month low after the Cabinet Office said gross domestic product shrank an annualized 0.4 percent in the three months ended Sept. 30, after sliding at a revised 3.7 percent rate in the previous quarter. Bonds also gained on expectations banks will have more money to invest in the market after the Bank of Japan changed policies to increase liquidity in the financial system.

``We are going to see a prolonged economic slowdown,'' said Takashi Nishimura, an analyst at Mitsubishi UFJ Securities Co., a unit of Japan's largest bank by assets, in Tokyo. ``If short- term money-market stability were to emerge, bond yields would look attractive, especially given the weak GDP figures.''

The yield on the 1 percent note due September 2013 fell 1.5 basis points to 0.865 percent as of 4:34 p.m. in Tokyo at Japan Bond Trading Co., the nation's largest interdealer debt broker. The price rose 0.070 yen to 100.626 yen.

Ten-year yields declined 2 basis points to 1.48 percent. A basis point is 0.01 percentage point.

Ten-year yields may fall to as low as 1.4 percent by year- end, Mitsubishi UFJ's Nishimura said. His forecast is lower than the 1.46 percent estimate in a Bloomberg News survey of economists and analysts. Should Nishimura's predictions prove accurate, investors will make a 0.8 percent return.

Ten-year bond futures for December delivery gained 0.19 to 138.56 as of the afternoon close at the Tokyo Stock Exchange.

Prolonged Slowdown

``The weakness in economic growth may give incentives to the BOJ to consider another rate cut,'' said Susumu Kato, chief economist in Tokyo at Calyon Securities, one of the 24 primary dealers required to bid at government debt sales.

There is a 13 percent chance the central bank will reduce interest rates by year-end, according to calculations by JPMorgan Chase & Co. using overnight interest-rate swaps. The BOJ on Oct. 31 cut its overnight target rate to 0.3 percent.

Japan's Economic and Fiscal Policy Minister Kaoru Yosano today said the downturn will continue for some time. The economy will shrink 0.1 percent next year, according to the Organization for Economic Cooperation and Development, less than the 0.9 percent and 0.5 percent contractions in the U.S. and Europe.

Gains in bonds may be limited after the Ministry of Finance on Nov. 14 said it may increase the sales of one-treasury bills and two- and five-year notes to local banks.

It may also sell more of the so-called super-long bonds that mature in 20, 30 and 40 years to life insurance companies and pension funds in the next fiscal year, an official indicated after a regular meeting with the nation's 24 primary dealers.

Inflation Bonds

The ministry will decide this week whether to cancel auctions of inflation-linked bonds and floating-rate notes scheduled for February as demand for such securities remained weak. Some traders at the meeting wanted to scrap the sales, while some wanted a change in the terms of the securities.

The government will offer 900 billion yen ($9.3 billion) in 20-year bonds this week.

``This week's 20-year issuance will be 100 billion yen more than the previous auction,'' said Chotaro Morita, head of fixed- income strategy research at Barclays Capital in Tokyo. ``Together with the outlook for next fiscal year's supply and demand, this may increase expectations the curve will steepen.''

The difference in yields between five- and 20-year debt expanded to about 128.5 basis points, the widest since April, according to data compiled by Bloomberg. Last year's average spread was 92 basis points.

Interest on Reserves

The BOJ last month said it will start paying 0.1 percent interest on reserves, encouraging finance companies to lend excess cash to the central bank. The Bank of Japan will provide extra funds for institutions that need money. The interest payments will also stop the overnight lending rate falling below 0.1 percent, allowing for the increased provisions of liquidity.

``The attention is on whether repo rates will decline as the BOJ starts to pay interest on reserves,'' said Kazuhiko Sano, chief strategist in Tokyo at Nikko Citigroup Ltd., a Japanese unit of the second-biggest U.S. bank by assets.

The loan call rate was at 0.295 percent in Tokyo, from 0.28 percent on Nov. 14, according to broker Tokyo Tanshi Co.

To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.

Last Updated: November 17, 2008 02:43 EST