Aug. 17 (Bloomberg) -- Japan's five-year notes had their biggest weekly gain since the government started issuing them in 2000 as concerns over a global credit crunch fueled demand for sovereign debt.

Ten-year bond futures for September delivery rose the most today since November 2003 as the yen climbed to the strongest in more than a year and the Nikkei 225 Stock Average plunged more than 800 points. The rout in equities prompted investors to reduce bets the Bank of Japan will raise interest rates at its meeting next week.

``The global markets are in a state of chaos and people are fleeing from risky assets to the safe haven of government bonds,'' said Koji Mori, who oversees the equivalent of about $397 million in mutual funds at Daiwa SB Investments Ltd. in Tokyo. ``A rate increase is a tough call in this environment.''

The yield on the benchmark five-year note today fell 9.5 basis points to 1.09 percent, the lowest since Sept. 27, as of 4:41 p.m. in Tokyo at Japan Bond Trading Co., the nation's largest interdealer debt broker. The price of the 1.4 percent note due June 2012 rose 0.438 yen to 101.417 yen. For the week, yields declined 19.5 basis points, the most since the government started selling them in February 2000.

Mori said he is keeping the average duration of his debt holdings longer than a benchmark he uses to gauge his performance. Duration measures sensitivity to changes in yields, and the higher an investment's duration, the more it returns when yields decline. A basis point is 0.01 percentage point.

17-Month High

Bond futures climbed to the highest in 17 months as the Nikkei 225 had its biggest points decline since April 2000. Shares slid on concern widening losses linked to U.S. subprime mortgages will slow growth in Japan's biggest export market.

Ten-year bond futures for September delivery rose 1.22 to 136.27 at the Tokyo Stock Exchange. They earlier climbed to 136.31, the highest since March 2006. Yields on 10-year bonds fell 6 basis points to 1.58 percent.

The yen traded at 112.38 per the dollar after rising to 111.61, the strongest since June 2006.

``The yen appreciation triggered more selling of equities, in a sense like flight to quality,'' said Maki Shimizu, a fixed- income analyst at UBS Securities Japan Ltd., one of the 25 primary dealers required to bid at government debt sales. Investors are ``disposing of low coupon bonds, cutting losses and getting into better positions.''

Rate Outlook

Investors see a zero percent chance the Bank of Japan will raise rates at its two-day meeting which ends on Aug. 23, according to Credit Suisse Group's figures, based on contracts for the overnight exchange of interest payments. The probability of an increase was as high as 69 percent last week.

The gain in bonds was limited by speculation yields are too low to compensate for the risk that borrowing costs will still rise later this year.

``The market condition is volatile but the economic conditions are in line for a rate hike,'' said Hitomi Kimura, a bond strategist in Tokyo at JPMorgan Securities Japan Co., another primary dealer. ``The Japanese economy is not weakening because of the credit crunch and liquidity crisis.''

Investors see about a 46 percent chance the BOJ will increase rates in September, according to Bloomberg calculations using overnight interest-rate swaps. The central bank raised its target for the overnight lending rate to 0.5 percent in February.

Japanese corporate bond risk rose amid concern the U.S. subprime mortgage rout may hamper financial companies' ability to repay debt, according to traders of credit-default swaps.

Corporate Bond Risk

Contracts on the benchmark iTraxx Japan Series 7 Index of 50 investment-grade Japanese companies increased 4 basis points to 42 basis points in Tokyo, according to Mitsubishi UFJ Securities Co. Each basis point is worth 1,000 yen on a swap that protects 10 million yen ($89,000) of debt. An increase indicates deteriorating investor perceptions of credit quality; a decrease suggests improvement.

Japanese banks including Mitsubishi UFJ Financial Group Inc. may face losses from their holdings of collateralized debt obligations and other asset-backed products, as risk aversion spreads from subprime mortgages to other markets.

``Direct exposure to subprime loans and mortgage lenders may be limited at Japanese banks,'' said Takahiro Tazaki, head of structured credit research at Barclays Capital in Japan. ``The bigger impact may come from price declines in a wider range of products such as asset-backed bonds, CDOs and hedge funds.''

Mitsubishi UFJ, Japan's biggest bank, Mizuho Financial Group Inc. and six others reported this month combined losses of 18.7 billion yen linked to investments backed by subprime loans. The disclosures represent less than 0.2 percent of their combined holdings of asset-backed bonds as of March 31, according to documents on their Web sites.

To contact the reporter on this story: Keiko Ujikane in Tokyo at kujikane@bloomberg.net.

Last Updated: August 17, 2007 03:44 EDT