Nov. 10 (Bloomberg) -- Japanese bonds gained, snapping a four-day drop, as yields near the highest since June and signs of deflation lured buyers.

Demand also increased at a Ministry of Finance sale of 300 billion yen ($3.3 billion) in 40-year bonds. The sale attracted more bids than the previous auction in July. So-called real yields, or what investors get after accounting for the cost of living, rose to the highest since 1995. A government report on Nov. 12 is forecast to show October wholesale prices dropped.

“There’s a risk of prolonged deflation,” said Eiji Dohke, chief strategist in Tokyo at UBS Securities Japan Ltd., one of the 23 primary dealers that are required to bid at government bond auctions. “Many market participants expect the Bank of Japan to keep on hold for a long time.”

The yield on the 1.3 percent bond due September 2019 fell half a basis point, or 0.005 percentage point, to 1.47 percent as of 4:29 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The yield earlier touched 1.485 percent, the highest since June 16.

Ten-year yields may slide to 1.3 percent by year-end, Dohke said. That means investors who buy the debt today would make a 1.7 percent return, according to calculations by Bloomberg.

Ten-year bond futures for December delivery rose 0.17 to 137.55 as of the afternoon close at the Tokyo Stock Exchange.

Lifer Demand

The sale of 40-year debt drew bids worth 3.45 times the amount on offer, compared with a so-called bid-to-cover ratio of 2.85 times at the July sale. The Ministry of Finance is scheduled to sell 2.4 trillion yen in five-year notes on Nov. 12.

“The 40-year auction went reasonably well,” Christian Carrillo, a senior interest-rate strategist at Societe Generale SA in Tokyo, wrote in a note. “It’s hard to make too much out of this auction in respect to strength for the whole super-long end, but clearly lifers are buying.”

Daido Life Insurance Co., a unit of Japan’s biggest publicly traded life insurer T&D Holdings Inc., yesterday said it plans to buy 50 billion yen of domestic bonds, after adding a similar amount in the first half.

Daido Life joins Japan’s four largest insurance companies-- Nippon Life Insurance Co., Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co.- -who last month also said they plan to add to domestic debt holdings.

Real Yields

Japan’s so-called real yields, or what investors get after accounting for the cost of living, climbed to about 3.8 percent, the highest since 1995, according to data compiled by Bloomberg.

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 survey before the Bank of Japan’s Nov. 12 report. Consumer prices fell 2.3 percent in September. Deflation, or a general drop in prices, enhances the value of a bond’s fixed payments.

“Ten-year yields near 1.5 percent will attract dip buyers,” said Tetsuya Miura, chief market analyst in Tokyo at Mizuho Securities Co., a unit of Japan’s No. 2 banking group.

Technical charts suggest recent drops in 10-year securities were too excessive. The 14-day relative strength index on 10- year yields climbed to 73 yesterday, higher than the 70 level that signals that the securities may be oversold and are poised to gain.

Stock Gains

Gains in bonds were limited as Asian shares continued a global equity rally on optimism economic stimulus measures will stay in place, sapping demand for fixed-income securities.

“The stock-market moves are sapping demand for bonds,” said Kazuhiko Sano, chief strategist in Tokyo at Citigroup Global Markets Japan Inc., another primary dealer. “I don’t see market sentiment improving.”

Japan’s Nikkei 225 Stock Average added 0.6 percent today, following a 2 percent jump in the Dow Jones Industrial Average to a 13-month high. Europe’s Dow Jones Stoxx 600 Index surged 1.9 percent yesterday, the most since Oct. 14.

U.K. Chancellor of the Exchequer Alistair Darling, hosting a meeting of finance ministers from Group of 20 nations, said his colleagues decided to keep interest rates low and maintain record budget deficits until economic recoveries take hold. Officials met in St. Andrews, Scotland over the weekend.

Fujii ‘Concerned’

Japanese Finance Minister Hirohisa Fujii acknowledged that Japan’s worsening fiscal health is one reason for the recent gain in yields and said the government will try to eliminate such worries by restraining spending.

“I’m very concerned” about the recent gain in yields, he told reporters in Tokyo today. “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.

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.

Fitch Ratings said it would have to review Japan’s AA credit rating should new bond issuance exceed 44 trillion yen, Reuters reported, citing David Riley, head of global sovereign ratings at Fitch.

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

Last Updated: November 10, 2009 02:37 EST