JGBs rally as 5-yr auction demand eases market worry

* 5-yr JGB auction draws solid demand, offsets fiscal worries

* 10-yr yield down 11 bps from 5-mth high hit this week

* Japan sovereign CDS tightening continues

By Shinichi Saoshiro

TOKYO, Nov 11 (Reuters) - Japanese government bonds rallied on Thursday, with 10-year futures jumping to a three-week high, as the market took heart from the solid results of a five-year debt sale after a recent string of poorly received auctions.

The 2.4 trillion yen ($27 billion) five-year auction helped allay concerns over Japan's fiscal situation that had sent the benchmark 10-year yield to a five-month high earlier in the week.

The auction's bid-to-cover ratio, a gauge of demand, rose to 3.7 from 2.17 at the previous auction in October, even as issuance was increased by 100 billion yen. The tail, the difference between the lowest and average prices and used as another gauge of an auction's success, tightened to 0.02 from 0.04. TENDER01

"Recent JGB selling had gone a little too far," said Nobuto Yamazaki, a fund manager at DIAM Asset Management.

"Investors are still worried about what next year's budget will look like, but if the government can pull it together and keep bond issuance somewhat under control, then the market will settle down and yields could pull back even further."

The JGB market has been rattled over the past month, bracing for likely issuance increases by the government to fund an expected tax revenue shortfall this fiscal year and help finance the country's spending plans for the next year.

Japan, the most indebted among industrialised nations, already said last month it would increase the amount of JGBs sold to institutional investors this fiscal year by 2.1 trillion yen to offset low demand for retail bonds. Thursday's five-year auction was the first to include this increase.

FISCAL WORRIES EASE

But fiscal concerns were eased after officials said this week that the government must ensure its spending plans did not rattle bond investors' confidence and try to keep next fiscal year's new JGB issuance below 44 trillion yen. [ID:nT218318]

JGBs had already rallied the previous day in light of these comments, and Thursday's strong five-year tender came as further confirmation that market sentiment was improving for the time being.

"There were some concerns that the five-year yield slipping below 0.7 percent would dampen demand before hand," said Noriyuki Fukuda, a fixed-income strategist at Morgan Stanley. "But the auction outcome showed that bearish market sentiment is on the mend and warming investors to bonds again."

The midpoint indication of five-year credit default swaps JPGV5YJPAC=MP on Japan's sovereign debt was around 71.5 basis points on Thursday, down roughly a basis point from the previous day and continuing to pull away from seven-months highs hit this week. But that was still higher than about 45 basis points three weeks ago.

December 10-year futures jumped 0.63 point to 138.49, having hit a three-week high of 138.51. They touched a three-month low of 137.29 on Monday.

Market players said short covering by funds including commodity trading advisers and buying by domestic banks in the underlying cash 10-year zone boosted futures.

The two-year yield was unchanged at 0.255 percent JP2YTN=JBTC. The five-year yield JP5YTN=JBTC fell 4 basis points to 0.685 percent.

The benchmark 10-year yield dropped 5 basis points to 1.375 percent, moving sharply away from a five-month high of 1.485 percent struck earlier in the week.

The 20-year yield JP20YTN=JBTC dipped 1 basis point to 2.120 percent.

The two- to 10-year yield spread tightened by 5.5 basis points to 112 basis points according to Reuters data. It hit a 3-½ year high of 121 basis points earlier this week.

The five- to 20-year spread, on the other hand, widened by 3.5 basis points to 147.5 basis points as the five-years outperformed. (Additional reporting by Stanley White; Editing by Chris Gallagher)