A groomer trims a dog’s coat at the Pet Mall inside the Aeon Mall Makuhari Shintoshin shopping mall in Chiba, Japan. Photographer: Tomohiro Ohsumi/Bloomberg

Jan. 10 (Bloomberg) — Morgan Stanley said inflation and overspending threaten to push Japan’s finances to the brink, amid signs government-bond investors are preparing for rising consumer prices.

An auction of inflation-linked sovereign notes yesterday drew a higher-than-expected price, as investors bid for 2.87 times the amount available. The benchmark 10-year yield on non-protected securities will probably climb to 0.84 percent by the end of 2014, delivering a 0.5 percent loss, based on analyst estimates and data compiled by Bloomberg. That would be the first negative return since 2003, according to Bank of America Merrill Lynch index data.

The Japanese government has two to three years to curb expenditures or face a possible crisis, according to Robert Feldman, the head of Japan economic research at Morgan Stanley MUFG Securities Co. The government is doubling the nation’s 5 percent sales tax in two steps from this year, as a more than 4 percent jump in welfare expenditures and debt servicing costs next fiscal year is set to outpace revenue growth, according to the Ministry of Finance budget plan.

“There’s the risk interest payments would swell should the government fail to cut budget deficits when inflation and yields grind higher,” Feldman said in an interview in Tokyo on Jan. 8. “Absent an increase in tax revenues stemming from a tangible improvement in the real economy, there is a risk of collapse.”

Linkers Demand

The ministry sold 300 billion yen ($2.86 billion) of 0.1 percent 10-year inflation-linked notes yesterday at 105.90 yen, exceeding the median estimate of 105.65 in a Bloomberg News survey of 13 traders. The bid-to-cover ratio was 2.87, compared with 3.74 at the prior auction on Oct. 8. Sales have resumes after a five-year halt, with the last offering in August 2008 getting 2.52 times the amount on offer.

The yield gap between 10-year nominal government bonds and linkers climbed five basis points, or 0.05 percentage point, to 1.08 percentage points yesterday, and was little changed today. The breakeven rate, which signals bond investors’ expectations of future inflation, may advance to as high as 1.4 percentage points this year, said Yuya Yamashita, a rates strategist in Tokyo at JPMorgan Chase & Co.

“What’s most important is if there will be wage hikes and also whether they will spread in the country, and I have a positive view on that,” said Yamashita. “All things equal, faster inflation increases nominal bond yields.”

Abenomics Impact

JPMorgan expects 10-year yields to finish this year at 0.8 percent, he said. The benchmark yield was little changed at 0.695 percent today, compared with 2.97 percent for similar-maturity Treasuries.

Japan’s government bonds due in one to 10 years have had posted annual losses only three times since 1986, a Merrill Lynch index shows. They last recorded a decline in 2003 at 0.67 percent after yearly slides in 1994 and 1989.

Prime Minister Shinzo Abe’s economic policy, which is made up of fiscal spending, monetary easing and growth initiatives, helped pushed inflation to the halfway point of the Bank of Japan’s 2 percent target. Consumer prices excluding fresh food rose 1.2 percent in November from a year earlier, the most in five years.

Social-security expenditures will rise 4.8 percent in fiscal 2014 and make up the largest part of total spending at 32 percent, according to the Ministry of Finance’s website. Debt servicing costs, which account for 24 percent of the total, will increase 4.6 percent while revenue grows 3.5 percent.

BOJ Purchases

The central bank has been buying more than 7 trillion yen of government bonds every month since April, keeping the nation’s borrowing costs at the lowest globally．

Economy Minister Akira Amari told reporters in Tokyo today the BOJ is steadily conducting its monetary policy and that the Group of 20 nations understand Japan’s easing isn’t targeted at foreign exchange rates.

The yen slid 0.2 percent to 104.97 per dollar as of 3:47 p.m. in Tokyo from yesterday after plunging 18 percent last year, the most since 1979. Depreciation typically enhances exporters’ competitiveness while boosting inflation through higher import costs. 　　“The BOJ might come in for more asset purchases” to alleviate the impact on the economy from the planned tax hike, said Alvin Liew, a Singapore-based economist at United Overseas Bank Ltd. “We expect longer-term JGB yields to edge higher in 2014 but not much.”

Tax Increase

The government will raise the sales levy by 3 percentage points to 8 percent in April and to 10 percent in October 2015. Abe needs to boost tax revenue to close the nation’s budget gap as the government struggles to pay for the care of the world’s fastest-aging society.

“Budgeting may become increasingly difficult, setting off an unstoppable negative debt spiral, that’s why bold spending cuts are necessary,” said Feldman, who previously served as an economist at the International Monetary Fund. “Relying too much on tax increases to improve fiscal health is extremely dangerous.”

Japan’s public debt has ballooned to more than 1 quadrillion yen. The nation’s net liabilities, or total debt less financial assets, will reach 142 percent of gross domestic product this year, compared with 88 percent for the U.S. according to estimates by the International Monetary Fund.

Bond Risk

The cost to protect Japan’s debt for five years against nonpayment was at 45 basis points yesterday, up from 40 at the end of last year, according to data provider CMA. The premium on the credit-default swaps plunged 42 basis points in 2013, following a 62 drop the previous year.

“You think where the crowded trades are in the system today — people are riding Japan,” Rick Rieder, the chief investment officer for fundamental fixed income at BlackRock Inc. the world’s biggest asset manager, said in a Bloomberg Television interview on Jan. 8. “It’s a good trade, but you got to watch it carefully.”

Japan is “the only place in the world where you have fiscal, structural and monetary policy,” said Rieder, who runs the $11.4 billion BlackRock Strategic Income Opportunities Portfolio. “They also have a burden that’s incredibly high in front of them in terms of the size of debt load. In 2014 are we going to have all the signs that things are going reasonably well? I think so in Japan.”

To contact the reporters on this story: Masaki Kondo in Singapore at mkondo3@bloomberg.net ; Shigeki Nozawa in Tokyo at snozawa1@bloomberg.net ; Mariko Ishikawa in Tokyo at mishikawa9@bloomberg.net

To contact the editors responsible for this story: Sandy Hendry at shendry@bloomberg.net ; Garfield Reynolds at greynolds1@bloomberg.net