Nov. 17 (Bloomberg) -- Japanese government bonds rose for a third week, pushing 10-year yields to the lowest in 21 months, as central bank Deputy Governor Toshiro Muto said global financial market turmoil may hurt the nation's economy.

The benchmark notes completed the longest series of weekly gains in eight months as Muto, a likely candidate to replace Governor Toshihiko Fukui, said yesterday the U.S. housing market slump may make it ``difficult'' to decide when to raise Japanese interest rates. Markets are ``unstable,'' Bank of Japan policy makers said in minutes of the Oct. 10-11 meeting.

``People think JGBs are very, very safe'' compared with lower-rated securities like corporate bonds, Xinyi Lu, chief strategist at the international treasury division at Mizuho Corporate Bank Ltd. in Tokyo, said yesterday. ``Financial institutions have to get a return on their money and need to buy JGBs.''

The yield on the benchmark 10-year note fell as much as 3.5 basis points to 1.46 percent, according to Japan Bond Trading Co., the nation's largest interdealer debt broker. The yield was 1.47 percent as of the close in Tokyo, taking the decline for the week to 5.5 basis points. The price of the 1.7 percent bond due September 2017 rose 0.218 yen to 101.975 yen. A basis point is 0.01 percentage point.

Ten-year bond futures for December delivery gained 0.19 to 137.04 as of the close yesterday on the Tokyo Stock Exchange.

The central bank on Nov. 13 kept its target for the overnight call rate, the main rate at which banks lend to each other, at 0.5 percent, the lowest among major economies.

U.S. Yield Spread

U.S. Treasuries rallied to the highest in more than two years on Nov. 15, reducing the extra yield paid by 10-year securities compared with similar-maturity Japanese debt.

The spread between the two notes narrowed to 2.70 percentage points from a four-year high of 3.36 percentage points on June 12, according to data compiled by Bloomberg.

``JGBs don't look very expensive compared to the U.S.,'' Mizuho's Lu said. The difference in yield will probably decline to 2.62 percentage points within a month, he said.

Global stocks fell, increasing demand for the relative safety of government debt, after Wells Fargo & Co. said it's ``not immune'' to what it said is the worst U.S. housing market since the Great Depression, and Barclays Plc wrote down $2.7 billion of securities tied to subprime mortgages.

Lu predicts that Japanese 10-year yields will fall to 1.38 percent in a month as U.S. 10-year yields decline to 4 percent from 4.16 percent yesterday.

Recession Risk

Gains were limited by speculation yields are so low they overstate the risk that the Japanese economy contracts. The 10- year note should yield 1.55 percent assuming a 30 percent chance of a recession in Japan, according to JPMorgan Securities Japan Co.

``Right now, more of the sentiment is driving the market,'' said Hitomi Kimura, a fixed-income analyst at JPMorgan in Tokyo, referring to the credit market turmoil. ``Once that phases out, theoretical value, or fair value, will come in.''

The yield on 10-year notes will probably increase to 1.6 percent by the end of the year and investors should delay any purchases until the security rises to 1.55 percent, she said.

The 10-year note will yield 1.8 percent by year-end while Treasuries will be at 4.39 percent, according to Bloomberg surveys of analysts, with the most recent forecasts given the heaviest weightings.

Default Risk Rises

The risk of companies and governments in the Asia-Pacific region defaulting on their debt increased yesterday on speculation losses on U.S. subprime mortgage securities will worsen and erode consumer confidence in the world's biggest economy.

The BOJ's Muto said policy makers ``are fully aware'' growth in Japan would be threatened should the U.S. slowdown infect the rest of the world. The housing crisis and banks' reluctance to lend have yet to damp spending by U.S. consumers and companies, he added.

Credit-default swaps on the benchmark iTraxx Japan Series 8 Index of 50 investment-grade Japanese companies, including All Nippon Airways Co. and Japan Tobacco Inc., rose 2.75 basis points to 42.5 basis points, Morgan Stanley prices show.

Investors' expectations for Japanese inflation over the next decade fell this week by the most in almost three months, judging by yields.

The extra yield paid by 10-year government debt compared with similar-maturity inflation-protected securities declined 5 basis points to 39 basis points this week, according to data compiled by Bloomberg.

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

To contact the reporter on this story: Oliver Biggadike in Tokyo at obiggadike@bloomberg.net.

Last Updated: November 16, 2007 18:23 EST