JGBs extend rally, 10-yr yield well off 7-mth high

By Rika Otsuka

TOKYO, May 9 (Reuters) - Japanese government bonds surged on Friday, with the benchmark 10-year yield dropping sharply from a seven-month high as investors rushed to buy paper at higher yield levels after putting a poor 10-year debt sale behind them.

On Thursday, buying emerged following the weak auction, confirming solid demand and prompting many market players to shift funds into JGBs.

Bond buying further gathered momentum on Friday, helped by falling stocks and overnight gains in U.S. Treasuries.

Pension funds aggressively picked up 10-year bonds, as well as recently battered five-year notes, while hedge funds bought futures, traders said.

"Investors are buying as they figured that bond yields had limited scope for a further rise after seeing the market hanging in there despite a weak auction," said Atsushi Ito, JGB strategist at Morgan Stanley.

"Today's rally gives the impression that investor bond buying is fairly strong," he said. June 10-year futures climbed 1.06 points to 136.86, before easing to 136.78 2JGBv1, up 0.98 on the day.

The benchmark 10-year yield fell 8.5 basis points to 1.555 percent JP10YTN=JBTC, well off a seven-month high of 1.680 percent struck this week.

The five-year yield was down 7.5 basis points at 1.105 percent JP5YTN=JBTC.

The Nikkei share average .N225 fell 0.9 percent.

Thursday's auction of 1.9 trillion yen ($18.3 billion) in 10-year JGBs with a 1.7 percent couponwas the week's focal point, as it took place just two weeks after JGB futures suffered their biggest one-day sell-off in five years.

The auction produced a tail of 0.26, the widest since a 10-year JGB auction in September 2006.

The wide tail, an indication of weak demand, likely reflected caution among brokerage houses, which have been hit by turmoil in credit markets and the recent volatility in JGBs, traders and analysts said.

CEILING FOR BONDS?

Despite solid demand, further gains may be limited in the short-term as investors have not altered expectations for the Bank of Japan to leave interest rates at 0.5 percent for a while.

"JGB yields will stay range-bound, overall, as long as the BOJ is expected to keep its neutral stance," said Hidenori Suezawa, chief fixed-income strategist at Daiwa Securities SMBC.