Thursday's auction of 20-year Japanese government bonds will serve as the first test of demand for ultra-long-term debt since the prime minister's election victory triggered a surge in buying.

In January, Japan's bond market experienced significant volatility, with yields jumping to multi-year highs due to fiscal concerns sparked by Sanae Takaichi's plan to cut the food consumption tax for two years. Market trends reversed after Takaichi unexpectedly secured an absolute majority, an election result that may provide her with breathing room to implement clearer policies and more restrained fiscal spending.

The yield on 20-year Japanese government bonds is currently hovering around 2.97%, a notable decline from the peak of 3.46% reached last month. The 3.46% level was the highest since 1997.

"The rapid decline in ultra-long-term rates following the election may discourage active participation by domestic institutional investors, such as life insurance companies, in the 20-year JGB auction," said Ryutaro Kimura, Senior Fixed Income Strategist at AXA Investment Managers.

As domestic life insurers remain cautious and the Bank of Japan reduces its bond purchases, the proportion of foreign investors in subscriptions is increasing, which amplifies volatility in the Japanese bond market. With yields now having fallen below 3%, this auction will test whether lower yields will dampen demand.

"The recent downward trend in ultra-long-term yields appears to be primarily driven by overseas investors," said Naoya Hasegawa, Chief Bond Strategist at Okasan Securities. "Therefore, this auction may serve as a test of whether this trend will persist following the significant yield decline."

PIMCO favors Japanese 30-year government bonds, and Mark Nash at Jupiter Asset Management is also making a long-term strategic bet that Japanese government bonds will rise. The 20-year bond futures contract, which had been quiet for years, has become a popular tool for overseas investors to hedge and position themselves while increasing their holdings of Japanese ultra-long-term bonds.

"The fundamental issue of supply-demand imbalance has not improved, and demand for ultra-long-term bonds continues to rely on overseas investors and pension fund rebalancing," wrote strategists including Takafumi Yamawaki at JPMorgan in a report. "Given the continued fragility of the yen bond market, we emphasize the need for ongoing measures to prevent rising interest rates from eroding the financial strength of domestic institutional investors and further weakening demand for Japanese government bonds."

Investors are still awaiting clearer information on how Takaichi will balance expanding defense and strategic industry spending alongside cutting the food consumption tax.

"It remains difficult to envision concerns about fiscal expansion completely dissipating at this stage," Hasegawa said.