June 30 (Bloomberg) -- Corporate bonds in Europe posted record returns in the first half, outperforming the region’s government debt and stocks, amid investor demand for higher- yielding assets that helped boost issuance to a record.

Investment-grade bonds returned an average 6.5 percent including reinvested interest this year, after losing 3.3 percent in all of 2008, the worst year since 1999, Merrill Lynch & Co. indexes show. Securities issued by property firms including Sydney-based Westfield Group, the biggest mall owner, and Hammerson Plc in London were among the best performers, handing bond buyers an average 16 percent.

Companies sold 699 billion euros ($984 billion) of new bonds this year, 55 percent more than the first half of 2008, according to data compiled by Bloomberg. Investors bought the debt as government bond yields plunged, stock dividends shrank and interest rates were slashed by central banks to combat the deepest economic slump since the Great Depression.

“Credit represents value, probably for the first time in some time,” said Peter Day, a fund manager at Barclays Global Investors in London, which oversees about 303 billion pounds ($501 billion) of fixed-income investments. Some of Day’s clients are selling government debt and buying corporate bonds for their higher yields, he said.

Corporate bonds returned the most since Merrill started compiling the data in 1996. The returns beat a 4.9 percent gain in Europe’s Dow Jones Stoxx 600 Index and a 5.5 percent rally in the MSCI World Index, the first time bonds beat stocks since the first six months of 2007, according to Bloomberg data.

Beating Governments

Returns on European company debt also exceeded those on government securities, which handed investors 0.9 percent, for the first time since the first half of 2007, Merrill data show. In the U.S., corporate bonds returned 9.2 percent this year, according to Bloomberg data.

The extra yield investors demand to own investment-grade company bonds instead of government debt narrowed to 2.84 percentage points, the smallest gap since Sept. 25 and down from a record 4.63 percentage points in March, Merrill Lynch’s Euro Corporate bond index shows. The spread is more than 100 basis points wider than a year ago and compares with an extra yield of 3.33 percentage points for U.S. company bonds.

“Credit has been the place to be amid unprecedented volume of new issues,” said Lucette Yvernault, who helps oversee $3.1 billion as a director of fixed income at Schroders Investment Management Ltd. in London. “A lot of new money has poured into the asset class as investors reach for yield.”

Default Risk

The cost of protecting European investment-grade corporate bonds with credit-default swaps fell more than 35 percent this year, according to data compiled by Bloomberg.

The Markit iTraxx Europe index of default swaps, which pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements, dropped 62 basis points to 114 basis points.

A basis point on a credit-default swap contract protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year.

The yield on five-year German government notes, Europe’s benchmark, fell to a record 2.04 percent March 6, from as high as 4.78 percent in June 2008, and was at 2.48 percent June 29.

Dividend yields on the Dow Jones Stoxx 600, Europe’s benchmark, tumbled from as high as 7 percent in March to 4.4 percent, according to data compiled by Bloomberg.

‘Return on Capital’

Investor attitudes changed from preserving capital to “a return on capital, driving a desire for higher-yielding positions,” said Kevin Doran, senior fund manager at private bank Brown Shipley & Co. in Manchester, England.

Westfield, the world’s biggest shopping mall operator, has $7.4 billion of outstanding bonds, including 600 million euros of 3.625 percent seven-year notes sold in June 2005, according to Bloomberg data. Hammerson, the U.K.’s third-largest real estate investment trust, has $2.7 billion of outstanding bonds, including 700 million euros of 4.875 percent securities maturing June 2015 that were issued three years ago.

All but two of the benchmark corporate bonds sold this year made money for investors that bought the notes when they were first issued, according to Societe Generale SA in Paris. Companies excluding banks and insurers sold 176 bonds of at least 500 million euros, compared with 58 in the first half of 2008, SocGen data show.

Swiss drugmaker Roche Holding AG issued $15.8 billion of fixed-rate euro- and pound-denominated notes in February in Europe’s biggest non-financial offering, rewarding investors with a profit of more than $155 million in just two days, Bloomberg data show.

New-Issue Premium

The so-called new-issue premium has narrowed since the beginning of the year. Bonn-based Deutsche Telekom AG offered a yield spread of 66 basis points more than its existing debt when it sold bonds in January, a gap that shrank to 9 basis points when it issued debt in May. A basis point is 0.01 percentage point.

For some utilities, the cost of financing has fallen to levels before the collapse of Lehman Brothers Holdings Inc. in September roiled credit markets, according to BNP Paribas SA analysts.

The European Central Bank reacted to the credit crisis by cutting its main refinancing rate to an all-time low of 1 percent, from 2.5 percent at the beginning of this year and as high as 4.25 percent in October. The Federal Reserve has lowered borrowing costs to between zero and 0.25 percent, from as high as 5.25 percent in September 2007.

Shrinking Gap

“New issue premiums have come in substantially for stronger names due to the huge demand for paper,” said Rajeev Shah, a credit strategist at BNP Paribas in London. “Some utilities, telecoms and non-cyclicals barely offer any spread pick-up for new bonds.”

Shrinking premiums may slow the pace of new issuance by damping investor demand, Shah said.

“Moreover, most investment-grade companies have now completed all their refinancing needs for this year, which may also put pressure on supply,” he said.

Companies including Rome-based Wind Telecomunicazioni SpA, Air France-KLM of Paris and Tesco Plc of Cheshunt, England, are taking advantage of investor demand by reviving the markets for high-yield debt, convertible bonds and asset-backed securities.

Convertibles, Junk

Wind, Italy’s third-largest mobile-phone company, started selling the equivalent of 2.7 billion euros of debt this week, in Europe’s biggest junk bond issue since October 2006, while U.K. retailer Tesco completed the first public sale of commercial mortgage-backed notes in two years this month.

Companies including Air France, U.K. grocer J Sainsbury Plc and PSA Peugeot Citroen, which said last week it’s planning a 500 million-euro fundraising, are leading about $14 billion of convertible bond sales that are either pending or have been completed this year, according to Bloomberg data. That’s up from $4.4 billion in the second half of 2008.

Convertibles offer holders the chance to swap bonds for stock if the shares rise to a preset level.

“I think we’re seeing a permanent shift in Europe, with companies now looking to go to the bond market for a greater proportion of their borrowing rather than depending on the bank market,” said Mark Lewellen, head of corporate origination at Barclays Capital in London.

To contact the reporter on this story: Caroline Hyde in London chyde3@bloomberg.net.

Last Updated: June 30, 2009 07:29 EDT