JGB futures edge up as 10-yr sale eases supply worries

* JGB 10-year auction draws solid demand from banks

* Prospect of 10-yr yield returning above 1.5% fades

* Two-yr yield drops to 3-yr low below 0.3 pct

* Overseas investors dump Y666.7 bln of JGBs last week

TOKYO, July 2 - Japanese government bond futures edged up near a three-month peak on Thursday after an enlarged 10-year bond sale drew solid demand, relieving worries about how the market would absorb rising supply to back government stimulus plans.

The smooth auction cemented bullish sentiment in the JGB market and encouraged investors to pick up bonds in shorter maturities, pushing the two-year yield further down to a three-year low, as well as helping futures erase earlier losses.

The Ministry of Finance's sale of 10-year JGBs produced prices higher than expected and the tail, or the difference between the lowest accepted price and the average price, was narrower than the issue sold last month before the auction amount was increased.

The tighter tail reflected investor acceptance of the market price and willingness to buy the bonds. A wider tail usually indicates that investors want a bigger premium.

"The auction went smoothly despite prior worries about a quick drop in yields and an increase in the issuance," said Tatsuo Ichikawa, chief strategist for RBS in Tokyo.

"The market will see more bond auctions with issuance increases. But given the 10-year sale -- the one people were most worried about -- went without problems, the chances that the market will see 10-year yields rising above 1.5 percent have receded."

The sale produced a bid-to-cover ratio of 2.26, down from 3.37 at the previous auction and the lowest since February. But the tail was 0.03, narrower than 0.06 in June and the same level as in May.

September futures edged up 0.02 point to 138.20, erasing earlier losses and recovering near a three-month high of 138.31 struck on Tuesday.

The yield on benchmark 10-year bonds edged up a basis point to 1.350 percent as investors sold them to take profits, but stayed near an earlier low of 1.340 percent that matched a three-month low hit the previous day.

Early last month, the yield on 10-year notes rose as high as 1.560 percent due to supply worries and talk of green shoots in the economy which had lifted domestic and overseas yields as well as global stocks.

The drop in the 10-year yield has picked up pace since mid-June as many investors accelerated bond buying after going slow on purchases earlier in the April-June quarter.

Yet, data from the MOF showed overseas investors have been net sellers of Japanese bonds for the 12th straight week since early April, dumping a total 2.73 trillion yen of debt.

Overseas investors have been repatriating funds from Japanese bonds after redemptions without rolling them over due in part to JGB's low yields, some market players and analysts said.

The auction size was raised by 200 billion yen to 2.1 trillion yen ($21.7 billion) from the June 10-year sale to help pay for fiscal stimulus plans. The coupon was set at 1.4 percent, down from 1.5 percent in June.

The two-year yield fell further to a three-year low of 0.275 percent, down 1.5 basis points on the day and its lowest since January 2006.

The five-year yield dipped a basis point to 0.690 percent, a touch above a more than four-month low of 0.680 percent struck earlier this week.

Super-long maturities faced selling by investors booking profits from recent market gains with the 20-year yield rising 2.5 basis points to 2.030 percent and the 30-year yield climbing 3.5 basis points to 2.185 percent.