* 5-year JGB yield hits record low of 0.135 pct
* Investors rush to buy bonds before interest rate cut to zero
* Yields far below banks' funding costs
* Some analysts see ominous parallel with JGB market crash in 2003
By Hideyuki Sano
TOKYO, Feb 7 The possibility that the Bank of Japan (BOJ) will take bolder action to ease monetary policy is driving Japanese bond yields to historic lows, with the five-year yield hitting a record low of 0.135 percent on Thursday.
Prime Minister Shinzo Abe has said he would choose a new BOJ leadership more keen to take bold measures to beat deflation when the terms of Governor Masaaki Shirakawa and his two deputies end on March 19.
The catalyst for hasty buying of short-term bonds, such as two-year and five-year notes, stem from worries the BOJ will crush interest rates literally to zero as it did during most of the time during 1999-2006, when the central bank tried to reflate the sagging economy with monetary easing.
Such fever-pitched demand for low-yielding bonds, beyond the cost of funding for key players such as banks, is an ominous sign of a bubble waiting to burst, especially at a time when investors are rotating from fixed income to riskier assets as the global economy steadily recovers, some analysts say.
"I think the five-year yield has gone way too low. Is there anyone who can make money at such low yields? No," said Hidenori Suezawa, chief strategist at SMBC Nikko Securities.
Outgoing BOJ chief Shirakawa has long resisted cutting interest rates to zero, preferring a looser target band of 0-0.1 percent, saying that having rates exactly at zero would kill money markets because there would be no incentives for trading.
But after he announced on Tuesday that he would step down in mid-March, three weeks earlier than planned, investors started to look beyond his term.
Abe, who has pressured the BOJ to take drastic easing steps to achieve inflation of 2 percent, is seen keen to appoint a person with dovish credentials to succeed Shirakawa.
"A new governor, whoever that will be, is supposed to take a different approach to monetary policy, to do something the BOJ hasn't done yet," said Tadashi Matsukawa, head of fixed income investment at PineBridge Investments in Tokyo.
"And a central bank can do only things to ease, to reduce rates and to buy more assets. When they buy assets, a big part of that will be in short-term bonds," he added.
Investors, who expect a new BOJ governor to do both, rushed to buy bonds, especially short-term debt, which they think is safer than longer-dated bonds given risks that aggressive easing could one day boost inflation.
On Thursday the two-year bond yield fell 2 basis points to 0.025 percent, down from around 0.10 percent at the end of last year and near a record low of 0.01 percent set in 2002.
As the BOJ already plans to buy more than 40 trillion yen of bonds a year, with more than half of that in short-dated notes, the shortage of short-term paper is causing a bit of a squeeze, a bond trader said.
"Many players were trying to cover short positions desperately. But I feel like people are becoming a bit stupefied...No one is thinking about funding costs now," said a trader at a Japanese brokerage firm.
The overnight call rate, at which banks lend money to each other, was about 0.08 percent on Thursday, more than three times higher that the two-year yield.
The overall funding costs of Japanese banks are above 1.0 percent, though banks have kept buying JGBs, saying they cannot find lenders and have to park excess funds in liquid assets such as JGBs.
But while investors piled funds into JGBs solely on expectations of the BOJ's moves, analysts note that historically, JGB yields mostly track bond yields elsewhere such as in U.S. Treasuries in the long term.
Thus, if U.S. Treasury yields rise further on hopes of a modest recovery in the global economy, JGB yields are likely to follow and the pain could be strong.
That is what happened in June 2003, when the global economy started to gain momentum while Japanese investors were pouring funds into bonds, believing that the country's deflation would result in extremely low bond yields.
Another parallel with 2003 was that the market was also excited at the time that a new BOJ governor, Toshihiko Fukui, who took office in March that year, would take bold action.
"You have to remember that in 2003, the five-year yield hit then-a-record low of 0.145 percent, and only three months later it shot up to above 1 percent," SMBC Nikko's Suezawa said.
"But I guess in dealing rooms today, there are very few people who have experienced that."