TOKYO, May 22 (Reuters) - Japan's record stock rally

faces an unfamiliar challenge from rising interest rates,

analysts said, with the return advantage of shares over bonds

lately shrinking to the lowest level in 15 years.

Higher energy prices linked to the Iran conflict have stoked

inflation expectations across the globe and sent up government

bond yields, which in Japan after years of sitting around zero

are now touching multi-decade or even record highs.

The return spread, calculated as the difference between the

Topix gauge's earnings yield and the yield on the 10-year

Japanese government bond, or JGB, was as small as 2.16

percentage points last week, the narrowest gap since March 2011.

When it's low, it means investors are not being paid much

for owning stocks which are riskier than bonds. It has since

widened to about 2.4 percentage points but is still well below

where it sat last April, around 5 percentage points, and could

hurt stock prices if investors decide they would rather own

bonds instead.

"We have reached a level where the market is becoming

conscious of stocks looking expensive relative to government

bonds, making shares more sensitive to rising rates," said

Shingo Ide, chief equity strategist at NLI Research Institute.

Japan is vulnerable to inflation and rates rising further as

it imports most of its energy. The yield on the benchmark

10-year JGB touched 2.8% this week, a level not seen since

October 1996, while other short- and long-term rates hit record

highs.

Japanese shares ended the week higher, with the Nikkei

notching a record closing high and the Topix up

0.7% on the week as companies in the AI supply chain rally.

Whether gains hold may depend on whether AI-driven growth

expectations can outpace rising rates. The equivalent yield

spread in the United States, comparing the S&P 500 and the

10-year U.S. Treasury, is already negative.

To be sure, U.S. stocks remain near record highs supported

by growth expectations strong enough to absorb higher yields,

Hiroki Takei, strategist at Resona Holdings, said.

In Japan, investors are less accustomed to rates at these

levels.

"Until now, rising rates had been brushed aside in favour of

growth expectations," said Naoki Fujiwara, senior fund manager

at Shinkin Asset Management, adding that if Japan's long-term

rates head toward 3% and U.S. long-term rates toward 5%, "we

will have finally reached a rate level that can no longer be

ignored."