Japan bonds drift higher as traders assess fiscal fallout from coalition defeat

TOKYO, July 22 (Reuters) - Japanese government bonds drifted higher on Tuesday as investors returning from a long holiday weekend assessed the fiscal implications of the ruling coalition's recent election defeat.

Benchmark 10-year JGB futures 2JGBv1 added 0.2 yen to 138.55 by 0350 GMT, after flipping between gains and losses earlier in the session.

Cash 10-year JGBs edged up, sending yields JP10YTN=JBTC down 1 basis point to 1.51%, after starting the day with small losses.

Japan's ruling coalition lost control of the upper house in Sunday's election, a widely anticipated setback that further eroded the authority of Prime Minister Shigeru Ishiba, who lost his majority in the more powerful lower house in October.

While the ballot does not directly decide the fate of Ishiba's administration, and the embattled leader has vowed to stay on for now, it could lead to policy paralysis or a bigger fiscal deficit, with leading opposition parties calling for debt-funded consumption tax cuts to ease the burden of rising living costs.

Ishiba has rejected calls for tax cuts in favour of cash handouts, paid using tax revenues, and Finance Minister Katsunobu Kato reiterated on Tuesday the government's stance that sales tax cuts are not appropriate.

Japan has the largest debt burden in the developed world at about 250% of its gross domestic product.

"The election defeat shows that the consensus among voters is 'no' to cash handouts, meaning that the consumption tax cuts advocated by opposition parties are looking more likely to be realised, although the scale and duration would still need to be determined," said Daisuke Uno, chief strategist at Sumitomo Mitsui Banking Corporation.

"The political situation remains fluid."

The 10-year JGB yield rose to the highest since October 2008 at 1.595% last Tuesday after opinion polls increasingly pointed to opposition gains. The 30-year yield JP30YTN=JBTC shot to an all-time peak of 3.2%, and the 20-year yield JP20YTN=JBTC leapt to the highest since November 1999 at 2.65%.

In the latest session, the 20-year yield added 1 bp to 2.535%. The 30-year and 40-year bonds had yet to trade on the day, ahead of an auction of 40-year securities on Wednesday.

The two-year JGB yield JP2YTN=JBTC declined 1 bp to 0.755%, and the five-year yield JP5YTN=JBTC slipped 1.5 bps to 1.025%.

Japanese yields were also helped lower by big drops in European and U.S. bond yields on Monday.