Jan. 26 (Bloomberg) -- Japan’s government bond market, the world’s biggest, is luring record foreign demand by offering the second-highest yields among the Group of Seven nations after adjusting for inflation, with data tomorrow forecast to show a third month of price declines.

Yields on Japan’s 10-year notes at 1 percent turn to 1.51 percent after accounting for deflation, trailing only Italy, and compared with so-called real yields of minus 0.89 percent for U.S. Treasuries. Foreign money managers bought a net 1.49 trillion yen ($19 billion) of bonds and money-market instruments in the first two weeks of this year after a record 21.3 trillion yen in 2011, Ministry of Finance data show.

The Bank of Japan this week cut its economic outlook for the current fiscal year and next, signaling little relief from more than a decade price declines that weigh on consumer spending. Deflation is good news for bonds, boosting the value of their fixed payments and helping the government finance deficits that have produced the world’s largest debt pile.

“The state of mild deflation in Japan is a given for domestic investors,” said Jun Kawakami, a market economist at Mizuho Securities Co., one of the 25 primary dealers obliged to bid at government debt sales. “For those overseas in inflationary countries, Japanese bonds are hugely attractive from a real yields perspective.”

Ten-year government bond yields of 2.067 percent in the U.S. and 1.994 percent in Germany become minus 0.89 percent and negative 0.106 percent respectively after accounting for inflation. Japan’s 10-year bonds yield 1.01 percent, the second lowest in the world after Switzerland’s 0.84 percent. The Japanese yield sank to 0.935 percent on Jan. 16, the lowest level since November 2010.

Lower Forecasts

“Japan’s economy isn’t destined to exit deflation,” Daisuke Uno, Tokyo-based chief strategist at Sumitomo Mitsui Banking Corp., said by telephone yesterday. Uno forecasts Japan’s 10-year yields to hold between 0.8 percent and 1.2 percent this year.

The statistics bureau in Tokyo will likely say that consumer prices fell 0.2 percent in December from a year earlier, following a 0.5 percent decline the previous month, according to median estimate of economists surveyed by Bloomberg.

The BOJ on Jan. 24 cut its growth outlook for the year that begins April 1 to 2 percent from an October estimate of 2.2 percent. In the year ending this March, the economy will contract 0.4 percent and prices will decline 0.1 percent, both lower than initially anticipated, while inflation is seen at 0.1 percent in fiscal 2012, the BOJ said in a statement.

Best Performer 2011

“Even if the Japanese economy does not experience negative growth in the new fiscal year, we are still far from declaring an end to deflation,” said Junko Nishioka, chief Japan economist in Tokyo at RBS Securities Japan Ltd. and a former Bank of Japan official. The BOJ may be forced to revise down its “bullish” inflation forecast down the road, she said.

Deflationary pressures have been exacerbated by gains in the yen that make imports cheaper. The yen outperformed all of its 16 major peers in 2011 for a second year as investors sought a refuge from the prolonged debt crisis in Europe.

The Japanese currency reached a post World War II high of 75.35 per dollar on Oct. 31. It touched an 11-year high of 97.04 per euro on Jan. 16, when Standard & Poor’s cut credit ratings on nine euro-area countries.

Foreign Reserves

The yen’s share of the global foreign-exchange reserves held at a six-year high of 3.8 percent in the third quarter last year, while holdings of euros fell to a three-year low of 25.7 percent, figures from the Washington-based International Monetary Fund showed. The U.S. dollar’s portion of foreign reserves climbed to 61.7 percent, down from 72.7 percent a decade ago.

Elsewhere in Japan’s credit markets, Japan Housing Finance Agency sold 223.4 billion yen of 1.44 percent 35-year bonds, according to an e-mailed statement from Nomura Holdings Inc. yesterday. Trading company Marubeni Corp. sold 20 billion yen in even amounts of five- and seven-year bonds at rates of 0.66 percent and 0.92 percent, Nomura said in a separate statement.

The extra yield investors demand to hold Japanese corporate debt instead of government securities was 49 basis points on Jan. 23, compared with 240 basis points globally, according to indexes compiled by Bank of America Merrill Lynch.

Five-year credit-default swaps on Japanese government bonds were at 132.34 basis points on Jan. 24, down from the all-time high of 154.8 on Oct. 4, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Budget Gaps

Japan wouldn’t be able to manage its finances if bond yields surged to 3 percent, Prime Minister Yoshihiko Noda said this month. Noda renewed his push this week to double the nation’s sales tax to 10 percent, even as his government said doing so won’t be enough to balance the budget by 2020.

Persistent deficits have added to the world’s biggest public debt burden, now estimated to reach 985.4 trillion yen in the year ending March 2012, up 6.6 percent from a year earlier, according to Ministry of Finance projection earlier this month. The debt will growth to 230 percent of gross domestic product in 2013, the Organization for Economic Cooperation and Development said on Nov. 28, compared with about 180 percent for Greece.

The surge in government borrowing has yet to translate into higher yields. Growing deposits at domestic banks have been channeled back into government debt, while non-Japanese holdings stood at 8.2 percent at the end of September, the most since 2008, BOJ data showed last month.

“The disaster of the euro is a big headache for managers of foreign-exchange reserves,” said Tomoko Fujii, a senior foreign-exchange strategist at Bank of America Merrill Lynch in Tokyo. “The yen and Japanese bond markets, which have the capacity to absorb huge capital inflows, continue to be a destination of choice for foreign central banks seeking to diversify their reserves.”

--Editors: Rocky Swift, Pavel Alpeyev

To contact the reporters on this story: Mariko Ishikawa in Tokyo at mishikawa9@bloomberg.net; Shigeki Nozawa in ?? at snozawa1@bloomberg.net

To contact the editors responsible for this story: Pavel Alpeyev at palpeyev@bloomberg.net; Rocky Swift at rswift5@bloomberg.net -0- Jan/25/2012 15:00 GMT