(Repeats story issued on Friday with no changes in text)
* JGBs seen vulnerable as govt finances reconstruction
* Credit Suisse sees 12 trln yen funding shortfall in FY11/12
* Watch for bank lending pickup to remove JGB market support
By Natsuko Waki
TOKYO, March 25 (Reuters) - The Japanese government bond market may finally be reaching a tipping point, with the issuance needs for post-quake reconstruction prompting domestic investors to demand higher yields to absorb yet more debt.
Abroad, Japan's massive and growing debt load has stirred worries, driving the cost of default insurance to historic peaks and prompting credit rating cuts to below Spain. At home, benchmark yields have not budged much from near 1 percent.
In a country with public debt twice the size of its $5 trillion economy, many fund managers here are reluctant to talk on the record about any fears about the bond market -- in part because they have to justify holding bonds in their super conservative portfolios.
But the direct damage from the March 11 quake and tsunami -- now seen as high as $310 billion, or about 6 percent of the economy -- is raising some doubts about whether already overloaded investors can absorb much more debt at such low yields.
Big Japanese banks -- a key pillar of support -- may cut back on JGB holdings for reconstruction lending, while insurers may need to sell to raise funds to pay claims. Household investors have traditionally shifted funds into higher-yielding foreign assets and prefer JGBs only at yields well above current levels.
"Yields are not going to rise in the short term but it does raise medium to long-term risks for the JGB market," Hidenori Suezawa, chief strategist at Nikko Cordial Securities.
Economists at Credit Suisse said the government may face a 12 trillion yen ($148 billion) funding shortfall in the fiscal year beginning in April.
Even if the Ministry of Finance takes measures to limit the increase in bond issuance, such as postponing planned corporate tax cuts, Credit Suisse warned it may not be enough to prevent a "significant deterioration" in the JGB market.
Before the quake and ensuing crisis at a nuclear power plant, the medium-term risks about bonds were being reflected in the JGB market via a steep yield curve, with investors gradually demanding a higher yield to hold long-term bonds relative to short-term paper.
Since the quake, the yield curve between 5-year and 20-year JGBs has steepened to 158 basis points and is holding close to last year's decade high of 167 bps.
Benchmark 10-year yields even rose slightly last week as the Nikkei share average plunged more than 10 percent, showing the need among insurers to sell. Yields are now at 1.220 percent, 40 basis points above seven-year lows touched last year.
Foreign players have gradually built up positions betting on debt troubles for Japan via credit rating cuts.
The five-year credit default spread for JGBs is now 95 bps, about 15 bps wider than pre-quake levels after briefly hitting a record above 120 bps last week -- above the spread of South Korea which has a lower credit rating.
Even Takahiro Mitani, chairman of Japan's $1.4 trillion state pension fund, is aware of the risk. He told Reuters in a February interview that Japan's debt could reach a "critical" point as early as 2016 unless it was tackled.
PIMCO warned earlier this year that there was little value in longer dated JGBs around current yield levels.
CATALYST FOR RETHINK
Mitsubishi UFJ Securities estimates that, in a worst case scenario, the impact on net government debt outstanding, compared to where this would otherwise have been, could be as much as 5-10 percent of GDP by 2014 as a result of the quake.
In other words, net government debt could rise to 150 percent of GDP in 2014 from around 130 percent in 2011.
"There is... the possibility of the natural disaster proving to be the catalyst to an investor rethink about the safety of JGBs," Mitsubishi UFJ said in a note to clients.
The quake may also prompt household investors, who still keep vast sums locked up in deposits yielding almost nothing, to keep searching for better returns abroad.
"Increased demand for foreign assets from Japan's private sector and growing revulsion against large portfolio shares for JGBs means first and foremost a weaker yen," it said.
In the coming years, rebuilding may help reflate the economy and end deflation, dealing another blow to JGBs, even if the fiscal effect can be mitigated by increased tax revenues.
One key to watch is the Japanese banks, which have lifted their holdings of JGBs as a share of total assets to a record high 18 percent and are one of the biggest regular buyers. A rebound in lending means banks would inevitably hold fewer JGBs.
Jim O'Neill, chairman of Goldman Sachs Asset Management, says Japan's effort to grow more via stronger productivity and lower corporate savings could have an adverse impact.
"An irony of a decline in corporate savings without an increase in government savings, is that while it might boost nominal GDP, it might also result in some of the funding fears that many have expressed for so long as it would make Japan more vulnerable to foreign sentiment," he said.
"In some ways, it seems like a lose-lose situation."
In the very near term, banks and institutions may be tempted to park their funds in the JGB market following the Bank of Japan's cash injection that lifted current account deposits at the central bank to a record above 41 trillion yen.
JGB auctions since the quake have drawn decent demand, including a two-year and a 20-year auctions.
JGBs have managed to overcome various risks this year, the biggest of which being the rating downgrades. Standard & Poor's for example, now rates Japan one notch lower than Spain.
Domestic investors have largely shrugged off the warnings, but more cuts may be on the way.
S&P said last week it was too early to judge the ratings impact given the scale of the ongoing disaster, with uncertainty from Japan's nuclear reactors and its future energy supply.
"Given the sheer magnitude of the current disaster, the rating on Japan could be affected if the debt burden were to increase materially above our pre-earthquake expectations due to a significant economic impact and reconstruction costs," said Takahira Ogawa, S&P's Japan credit analyst. (Additional reporting by Akiko Takeda; Editing by Eric Burroughs)