* Commercial paper rate falls as credit market improves
* Fall in fund demand also reflects weak capex plans
* Service sector sentiment improves for 4th straight month
By Hideyuki Sano and Stanley White
TOKYO, May 13 (Reuters) - Interest rates on new Japanese commercial paper hit a 2-1/2-year low in April as firms felt less need to hoard cash, in a sign that funding strains are easing for some companies.
Analysts say lower commercial paper rates also reflect companies' reluctance to spend on equipment, which may hamper an economic recovery.
While the Bank of Japan's aggressive buying of commercial paper and government guarantees on loans for small firms have helped lower borrowing costs for many big companies, a steady rise in corporate bankruptcies shows other firms are being left out.
"It's hard to be optimistic now. Capital spending, employment -- those vital components of the economy are deteriorating," said Koji Ochiai, a senior market economist at Mizuho Investors Securities.
The average rate on three-month commercial paper issued in April fell to 0.45 percent, the lowest since October 2006, from 0.66 percent in March and about a third of the peak of 1.48 percent set in November, BOJ data showed on Wednesday.
Outstanding commercial paper held by banks fell 15.4 percent in April from a year earlier, the largest fall in more than two years, but analysts said it reflected reduced funding needs rather than difficulty in issuing commercial paper.
The market seized up after the collapse of U.S. investment bank Lehman Brothers in September sent shock waves through world financial markets.
In the aftermath the BOJ pledged to buy up to 3 trillion yen ($31 billion) of commercial paper and the government promised to guarantee loans for small firms as a part of a stimulus package.
Japanese bank lending grew 3.4 percent in April from a year earlier, below a record 3.7 percent rise in January, when a freeze in capital markets was forcing companies to flock to bank lending.
SIGNS OF RECOVERY
A BOJ official said growth in lending is likely to slow in the coming months as cash hoarding by firms seems to have run its course.
But some economists say companies' fund demand has also fallen because they are drastically cutting back on capital spending and cutting jobs to cope with the global downturn.
The number of corporate bankruptcies in April fell 13.5 percent from March but was up 9.4 percent from a year earlier, marking the 11th straight month of annual increases, a research firm survey showed on Wednesday.
While the government's loan guarantee scheme helped reduce the number of small construction firms going under, bankruptcies of manufacturers and retailers continued to rise on weak overseas and domestic sales, the survey showed.
Japan is mired in its worst recession since World War Two but exports and output have shown some signs of recovery, adding to hopes the worldwide slump may be nearing a bottom.
On a positive note, confidence in the service sector rose as government stimulus schemes, which include one-time payments to citizens, tax breaks for environment-friendly cars and lower expressway tolls, filter through the economy.
Service sector sentiment rose in April for a fourth consecutive month, to 34.2 from 28.1 in March, a government survey showed on Wednesday. It hit a record low of 15.9 in December.
Leading central banks have said the global economy is about to turn the corner, although there were signs recovery could be long and painful.
Japanese exports in March were almost half the levels of a year earlier but rose on a seasonally adjusted basis from February, the first monthly pickup since May last year, trade balance data showed last month.
The nation's current account surplus fell a less-than-expected 48.8 percent in March from a year earlier, data showed on Wednesday.
The world's No. 2 economy probably shrank 4.2 percent in the first quarter, economists polled by Reuters estimate, putting it on track for its deepest quarterly contraction in modern history.
The expected decline, after a 3.2 percent fall in October-December GDP, would mark the fourth straight quarter of economic contraction and would wipe out all of Japan's growth since mid-2003. ($1=97.34 Yen) (Editing by Chris Gallagher)