Japanese government bond (JGB) prices rose on Friday, reacting to a fall in the stock market after news that three Japanese civilians had been taken hostage in Iraq, but analysts said the outlook was unclear.
They said the incident had taken the Japanese government bond market by surprise and that players needed more time to determine the market's direction.
"The outcome for the Japanese government bond market, superficially and in the short run, is lower equities prices, which means higher Japanese government bond prices," said John Richards, Japan strategist at Barclays Capital.
"In the longer run, depending on how it plays out, it isn't so obvious."
Tetsuya Miura, a strategist at Shinko Securities, agreed.
"This is the first time Japan has had to deal with something like this. The market could lean either way over the country's policy on Iraq," he said.
Arab television station Al Jazeera broadcast a video on Thursday showing three Japanese it said had been taken hostage by an Iraqi group that had vowed to kill them if Japanese troops did not leave Iraq within three days.
Prime Minister Junichiro Koizumi said Japan had no plan to withdraw its troops from Iraq.
Many players were unwilling to take risks ahead of the weekend and 10-year Japanese government bond futures ended afternoon trading up just 0.18 point at 137.43. On Tuesday, they hit 136.64, the lowest in nearly five months.
The yield on the benchmark 10-year Japanese government bond fell 0.5 basis point to 1.485 percent at 0615 GMT. Earlier this week, the yield hit 1.535 percent, a level not seen since November.
Some analysts said the hostage crisis could have deeper political ramifications in the long run. Richards said public opposition to the deployment of Japanese troops in Iraq could grow and weaken Prime Minister Junichiro Koizumi politically ahead of Upper House elections in July.
"If Koizumi is regarded as substantially weakened (in the election), almost all the alternatives are not as fiscally conservative as he is, so that would be negative for bonds," he said.
And any collapse in stock prices due to political instability could have a big impact on banks, which still have large stockholdings and are also the largest holders of Japanese government bonds.
"They could easily stop buying or start selling (JGBs) to lighten their risk, which would start to give you higher pressure on interest rates," Richards said.
The key Nikkei stock average ended Friday down 1.61 percent at 11,897.51.
The Bank of Japan kept monetary policy unchanged on Friday amid signs of a broadening economic recovery, highlighted by its economic report for April, which said domestic demand was improving.
The policy decision, which was widely expected by the market, had little impact on Japanese government bond prices.
The BoJ also set the terms for a previously announced lending facility, under which it will sell government securities through repurchase agreements to improve the liquidity of bonds and bills.
The government will sell Japanese government bonds, treasury bills and financing bills held by the BoJ depending on market conditions - for example, when it is believed that liquidity in the issues could decline significantly and negatively affect the markets.
"It will help to make the market more liquid, which would be a good thing, because that would presumably mean slightly lower interest rates," said Barclays' Richards.