Oct. 12 (Bloomberg) -- Japan's government notes advanced, halting a three-day slide, as stocks declined and demand increased at today's auction of five-year notes.

Investors placed more bids for the debt, which pays the highest coupon since August, than at last month's sale. Five- year yields fell from near the highest in two months as stocks dropped by the most in more than three weeks. Purchases of debt rose after central bank board member Atsushi Mizuno failed to win support for an interest-rate increase yesterday.

``The BOJ didn't look as hawkish as people expected,'' said Hitomi Kimura, a bond strategist in Tokyo at JPMorgan Securities Japan Co., one of 26 primary dealers obliged to bid at debt sales. Auction demand was ``a bit better than last time.''

The yield on the 1.1 percent note due in September 2012 declined 5 basis points to 1.235 percent as of 3:02 p.m. in Tokyo at Japan Bond Trading Co., the nation's largest interdealer debt broker. The price rose 0.231 yen to 99.373 yen. A basis point is 0.01 percentage point.

The Ministry of Finance sold 2 trillion yen ($17 billion) of 1.3 percent five-year notes at an average price of 100.20 today. Orders for the debt increased to 3.26 times the amount on offer from a so-called bid-cover ratio of 3.13 in September.

Ten-year bond futures for December delivery gained 0.42 to 134.72 on the Tokyo Stock Exchange. The Nikkei 225 Stock Average fell 0.7 percent, snapping a three-day rally.

BOJ Rate Outlook

Japan's bonds often move in the opposite direction to stocks. Benchmark 10-year yields had a correlation of 0.95 with the Nikkei 225 in the past three months, according to Bloomberg data. A value of 1 means the two moved in lock step.

``Investors want to see whether the yields are going up further as they are recovering from the drop caused by financial market turmoil in August,'' said Susumu Kato, chief economist in Tokyo at Calyon Securities. ``It's a tough call for investors also because the timing of the next rate increase remains unclear.''

The chance the BOJ will increase borrowing costs at its meeting ending Nov. 13 fell to 9 percent from 16 percent yesterday, according to calculations by Credit Suisse Group using overnight index swaps.

The central bank kept interest rates unchanged at 0.5 percent yesterday because it needs more time to gauge the effect of the U.S. subprime-mortgage crisis on the global economy, Governor Toshihiko Fukui said. Mizuno was the sole advocate for an increase for a fourth consecutive meeting.

Inflation Expectations

Gains in bonds were tempered on speculation inflation will quicken and reduce demand for fixed-income securities. Governor Fukui yesterday said core consumer prices, which exclude fresh food, will increase ``before long'' and inflationary pressure ``is mounting gradually.'' The consumer price index fell by 0.1 percent from a year earlier in August.

``Our economists see CPI to increase to 0.1 percent in November,'' said Takashi Nishimura, an analyst at Mitsubishi UFJ in Tokyo. ``We may see a turning point in the Japanese inflation-linked bond market.''

The extra yield paid by 10-year conventional government debt compared with similar-maturity inflation-linked bonds was 41 basis points compared with 34 basis points a week ago, according to data compiled by Bloomberg.

The so-called breakeven inflation rate reflects investors' expectations for average annual increases in consumer prices over the next decade.

Demand for five-year notes increased relative to longer maturities after the BOJ released yesterday's vote count.

The gap in yields between five- and 20-year debt widened 5 basis points to 99 basis points today, compared with 94 basis points on Oct. 10 before the central bank meeting, according to data compiled by Bloomberg.

The government paid an average yield of 1.256 percent at today's five-year auction, less than the 1.27 percent yield on the current benchmark prior to the sale.

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

Last Updated: October 12, 2007 02:08 EDT