JGB futures fall on caution ahead of 10-year sale

* MOF offers Y2.1 trln of 10-yr JGBs with a 1.4% coupon

* Dealers cautious on absorption of extra Y200 bln

* Market eyes strength of demand from Japanese banks

TOKYO, July 2 - Japanese government bond futures fell on Thursday, edging down from a three-month peak struck this week as market players grew cautious ahead of the results of a 10-year note sale with an increased issuance size.

The auction is seen as a litmus test of whether investors will keep buying debt or pause after the start of the July-September quarter.

Some market participants warned that a weaker-than-expected result would prompt investors to rush to take profits from the recent rally which had sent the benchmark 10-year yield down to a three-month low.

"Bond dealers are cautious about how well the extra issuance of the 10-year bonds will be absorbed. The result will depend on whether Japanese banks show strong demand or not," said a fixed-income analyst at a European bank.

The Ministry of Finance set a 1.4 coupon for the sale of the 10-year JGBs, down from 1.5 percent for the issue sold last month and matching the level of the April issue.

The size of the issuance was raised by 200 billion yen to 2.1 trillion yen ($21.7 billion) from the sale of the maturity last month, to pay for fiscal stimulus plans.

The MOF will announce the results at 0345 GMT.

It is the first time ever for the benchmark note monthly sale to top 2.0 trillion yen -- the psychologically key level which debt management officials have avoided in a bid to encourage smooth market absorption during past issuance size increases.

The JGB market rally since mid-June has underscored strong demand for bonds with many investors accelerating bond buying after going slow on purchases earlier in the April-June quarter.

Investors had held back from buying bonds due to worries about rising supply as well as talk about green shoots which had lifted domestic and overseas yields as well as stocks.

"The auction is seen drawing sufficient demand although the tail might widen," said a trader at a Japanese bank. The tail is the difference between the lowest accepted price and the average price.

September futures fell 0.15 point to 138.03, below a a three-month high of 138.31 struck on Tuesday.

The benchmark 10-year yield rose a basis point to 1.350 percent, off an earlier low of 1.340 percent that matched a three-month low hit the previous day.

The five-year yield edged up half a basis point to 0.705 percent, above the 0.685 percent hit earlier this week, its lowest since late February.

The two-year yield was flat at 0.290 percent, staying below 0.3 percent at the lowest level since January 2006 and below the BOJ's Lombard lending rate.