By Theresa Barraclough and Yasumasa Song Dec. 2 (Bloomberg) -- Japan’s government bonds will rally over the next four months as a recession in the world’s second- largest economy deepens, Principal Global Investors and Fukoku Mutual Life Insurance Co. said. The funds, which manage $282 billion combined, are keeping the duration of debt holdings longer than their benchmarks and expect 10-year yields to decline about 15 basis points to 1.2 percent by the end of March, the lowest since 2005. Government reports last month showed Japan’s economy entered its first recession since 2001, industrial production declined more than expected and inflation slowed. “The economy now is just as dire as it was in 2005, so one would argue that yields should reach similar levels,” said Guthrie Williamson, a Sydney-based portfolio manager at a unit of Principal Financial in Des Moines, Iowa, which manages $228 billion in assets. “Economics point to lower yields.” Ten-year yields fell four basis points to 1.35 percent in Tokyo today, according to Japan Bond Trading Co., the nation’s largest interdealer debt broker. Investors will make a return of 1.7 percent should Williamson’s predictions prove accurate, according to Bloomberg calculations. Duration is a reflection of a bond’s maturity and expected payments. Rate Cuts “There is nothing to do other than to buy government bonds,” said Yuuki Sakurai, general manager of investment planning in Tokyo at Fukoku Mutual Life, which manages $54 billion in assets. “Yields will gradually decline.” Still, some funds are shunning the world’s lowest-yielding government debt in favor of euro securities. Pacific Investment Management Co., manager of the world’s biggest bond fund, and Fischer Francis Trees & Watts Inc., part of BNP Paribas SA, France’s largest bank, are going “overweight” European bonds while being “neutral” to Japanese debt. “Downside room to the U.K. and European yields is very big,” said Tomoya Masanao, an executive vice president in Tokyo at Pimco. “The Bank of England will be aggressive when they decide to cut.” The BOE is likely to lower interest rates to 1.5 percent by the end of March, from 3 percent, according to a Bloomberg News survey of economists and analysts. The European Central Bank’s target rate will fall to 2 percent in the same period, from 3.25 percent, according to a similar survey. There is a 21 percent chance the Bank of Japan will lower interest rates by the end of March, according to calculations by JPMorgan Chase & Co. using overnight interest-rate swaps. Europe Versus Japan “European bonds are much more attractive than Japanese debt,” said Naruki Nakamura, a Tokyo-based portfolio manager for Fischer Francis. “We have been overweight in duration since August both in U.S. and European bonds.” Japanese bonds have handed investors a return of 0.86 percent so far this quarter started Oct. 1, the least among Group of Seven nations, according to indexes compiled by Merrill Lynch & Co. German bunds returned 6.46 percent and gilts have returned 5.62 percent in the same period. The difference in yields between Japan’s 10-year government bonds and similar-dated German bunds shrank to 1.75 percentage points yesterday, the narrowest since October 2005, according to Bloomberg data. Bond Buybacks Japanese government bonds may also rally after Federal Reserve Chairman Ben S. Bernanke said the U.S. central bank may purchase Treasuries, spurring speculation the Bank of Japan will conduct similar operations, according to Mitsubishi UFJ Securities Co. “Bernanke’s remarks raised speculation that the BOJ will follow suit,” said Takashi Nishimura, an analyst in Tokyo at Mitsubishi UFJ, a unit of Japan’s largest bank. Investors should buy 10-year bonds as the economy faces “a prolonged recession,” he said. The U.S. economy “will probably remain weak for a time,” even if the credit crisis eases, Bernanke said yesterday. The Fed may buy “longer-term Treasury or agency securities on the open market in substantial quantities,” he said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.” The Bank of Japan started an emergency board meeting today to discuss expanding the range of corporate debt it accepts from lenders to encourage banks to increase funding for businesses. Governor Masaaki Shirakawa will brief the press at 3:30 p.m., the central bank said on its Web site yesterday. To contact the reporter on this story: Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net; Yasumasa Song in Tokyo at ysong9@bloomberg.net.

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