* 40-year bond auction outcome better than some expected
* Fixed-income gains appeal as stocks skid on Fed uncertainty
By Lisa Twaronite
TOKYO, Aug 20 (Reuters) - Japanese government bonds erased early losses on Tuesday as a sale of 40-year debt proceeded smoothly and Japanese shares swooned.
Japan's Nikkei stock average tumbled 2.6 percent, its biggest drop in two weeks, to end at its lowest since June 28. Markets have sagged as they await signals on when the U.S. Federal Reserve will taper its monthly $85 billion in asset purchases, which many believe could begin next month.
"Bonds weakened in the morning ahead of the 40-year auction, and then after the sale, weaker equities had the opposite effect on rates," said Tomohiro Miyasaka, an analyst at Credit Suisse in Tokyo.
The Ministry of Finance offered 400 billion yen ($4.08 billion) of 40-year bonds, reopening the current issue with a 1.9 percent coupon.
The notes sold at a lowest price of 99.45 yielding 1.92 percent, below market expectations of 1.93 percent. The sale drew bids of 3.37 times the amount offered, up from the previous sale's bid-to-cover ratio of 3.51 times, indicating more demand for the bonds.
The Bank of Japan held more than 40 percent of the outstanding issuance of the current 40-year issue as of end-July, which strategists and market participants said had made it difficult to value the issue.
The yield on the benchmark 10-year JGB fell 1.5 basis points to 0.745 percent, pulling away from a session high of 0.770 percent and back toward a three-month low of 0.730 percent hit last week.
"There are plenty of domestic investors who want to sell below 0.7 percent and buy above 0.85 percent," said a strategist at a Japanese brokerage.
Ten-year JGB futures closed up 0.26 point at 143.99 after ending morning trade flat. Volume of 20,825 was relatively light but was still the heaviest in a week, in thin summer conditions.
The superlong tenor also gained, with the yield on 20-year debt falling 1.5 basis points to 1.670 percent and the 30-year yield shedding one basis point to 1.800 percent.
Although JGBs have mostly focused on domestic supply and demand factors, a continuing sell-off in U.S. Treasuries had discouraged JGB buyers. However, a recovery in U.S. debt on Tuesday helped sentiment.
The yield on the benchmark 10-year Treasury notes fell to 2.82 percent in Asia from its U.S. close of 2.88 percent on Monday, when it rose as high as 2.90 percent. That was its highest since July 2011, and up sharply from 1.60 percent in early May, before the U.S. Federal Reserve started signalling its intentions to pare back its quantitative easing if the economy continued to strengthen.