Oct. 14 (Bloomberg) -- Japan’s five-year notes rose as yields near the highest in three weeks and a drop in local stocks encouraged investors to buy government debt.

Two-year notes gained for the first time in a week as Bank of Japan policy makers kept interest rates at 0.1 percent at the end of a two-day policy meeting. Demand for longer-dated bonds may increase after a central bank report today showed producer prices fell for a ninth month in September.

“Shorter-dated notes are being supported by a decline in stocks,” said Koji Ochiai, senior market economist in Tokyo at Mizuho Investors Securities Co., a unit of Japan’s second- biggest bank. “Interest rates won’t rise for a while.”

The yield on the 0.7 percent bond due September 2014 fell 1.5 basis points to 0.59 percent as of 4:30 p.m. in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price rose 0.071 yen to 100.525. Yields climbed to 0.615 percent yesterday, the highest since Sept. 18. A basis point is 0.01 percentage point.

Two-year yields declined one basis point to 0.24 percent, or 14 basis points higher than the BOJ’s overnight lending rate. Ten-year yields were unchanged at 1.295 percent. Bond futures for December delivery added 0.09 to 139.18 as of the afternoon close at the Tokyo Stock Exchange.

The Nikkei 225 Stock Average fell for the first time in six days after analyst Meredith Whitney said she was “far less bullish” on banks and cut her investment recommendation on Goldman Sachs Group Inc., citing valuations. The Nikkei 225 lost 0.2 percent and the broader Topix index fell 0.8 percent.

Stocks Decline

“Investors will probably buy on dips as the environment has improved for bonds,” said Kazuhiko Sano, chief strategist in Tokyo at Citigroup Global Markets Japan Inc., one of 23 primary dealers required to bid at bond auctions. “Although the BOJ’s corporate support program will be eventually ended, it may not be decided at today’s meeting.”

Demand for debt also increased after the central bank said the costs companies pay for energy and unfinished goods declined 7.9 percent in September from a year earlier, after sliding a record 8.5 percent in August.

Since lowering rates in December, the Bank of Japan started buying commercial paper and corporate bonds from lenders and offering them unlimited loans backed by collateral to channel funds to companies. The policy board in July extended those steps to Dec. 31. Policy makers today refrained from saying whether they would end the program.

Smaller Borrowers

Bank of Japan Governor Masaaki Shirakawa said earlier this month the need for the measures has diminished because companies have regained access to private funding and credit markets have stabilized. The bank may want to take more time to examine whether ending the programs will exacerbate the yen’s advance. Small companies are still struggling to borrow, members of Prime Minister Yukio Hatoyama’s Cabinet have said.

There is a 42 percent chance that Japan’s central bank will lift rates by the end of next year, according to calculations by JPMorgan Chase & Co. using overnight interest-rate swaps.

Five-year notes protected against inflation yielded 1.11 percentage points more than similar-dated regular notes today, compared with 1.06 percentage points at the beginning of last week, Bloomberg data showed. Inflation-adjusted securities typically yield less than regular bonds because their principal payment increases at the same rate as inflation.

Gains in bonds were limited on speculation primary dealers reduced holdings before the Ministry of Finance sells 2.3 trillion yen ($25.9 billion) in five-year notes tomorrow.

“Investors are probably cutting their holdings as they want the five-year yield to remain relatively high for the auction,” said Akio Kato, Tokyo-based team leader for Japanese bonds at Kokusai Asset Management Co., which runs the $47 billion Global Sovereign Open fund.

Primary dealers, which are required to bid at government debt sales, often reduce holdings of bonds in case prices decline before they can pass on the new securities to investors.

To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net; Yoshiaki Nohara in Tokyo at ynohara1@bloomberg.net.

Last Updated: October 14, 2009 03:43 EDT