July 1 (Bloomberg) -- Nowhere is the recovery in financial markets more evident than in corporate bonds, where Lehman Brothers Holdings Inc.’s bankruptcy is becoming a distant memory.

U.S. investment-grade company debt returned 9.2 percent in the first half of the year, outperforming Treasuries by 13.7 percentage points, the most on record, according to Merrill Lynch & Co. index data. Corporate bonds also did better than the Standard & Poor’s 500 Index of stocks, marking the first time since 2002 that the fixed-income securities outshined both Treasuries and equities.

The gains may be the clearest indication that the more than $12.8 trillion pledged by the government and Federal Reserve to thaw frozen credit markets is starting to pull the economy out of the worst recession since the 1930s. Frankfurt-based Deutsche Bank AG boosted its forecast yesterday for global economic growth next year to 2.5 percent from 2 percent.

“The only way to justify the kind of valuations six months ago is if we were in the process of creating the next Great Depression,” said Joseph Balestrino, a money manager at Pittsburgh-based Federated Investors Inc., which oversees $409 billion of assets.

Yields on investment-grade company securities fell to within 3.31 percentage points of Treasuries yesterday, the least since Sept. 10, according to Merrill’s U.S. Corporate Master Index. Spreads widened to a record 6.56 percentage points on Dec. 5, and the securities lost 6.8 percent in 2008, the worst year on record, as the shock to financial markets from Lehman’s collapse Sept. 15 froze credit markets and sparked a run on Treasuries that caused bill rates to fall below zero.

‘Overblown’ Fears

The rally shows fears that Lehman’s failure would create a domino effect that brought down the financial system were “overblown,” said Arthur Tetyevsky, chief fixed-income strategist at CF Global Trading LLC, a New York-based firm that trades securities for institutional investors, primarily U.S. and European hedge funds.

“Spreads on corporate debt were so out of whack coming into the year, implying default rates that indicated more than 20 percent of all speculative-grade companies would go bankrupt,” said Kevin Sherlock, co-head of loan and high-yield capital markets at Deutsche Bank in New York. “The risk appetite is far more aggressive now than it was three months ago. It’s about where we were last summer at pre-Lehman levels.”

Best Since Milken

The biggest returns came in the riskiest securities. High- yield, high-risk bonds gained 29 percent, or 34 percentage points more than Treasuries, Merrill Lynch indexes show.

The performance is the best since a market for the securities was created in the 1980s by Michael Milken, according to Merrill Lynch’s U.S. High-Yield Master II index. Junk bonds are rated below BBB- at S&P and less than Baa3 by Moody’s Investors Service.

Bond bulls are encouraged by signs the economy may be recovering. Consumer spending rose in May as benefits from the Obama administration’s stimulus plan spurred a jump in American incomes. The 0.3 percent increase in purchases was the first gain in three months, the Commerce Department said June 26. Incomes climbed 1.4 percent, the most in a year, driving the savings rate to a 15-year high. Another report showed consumer sentiment rose in June to the highest level since February 2008.

Treasury Losses

“The pace of economic contraction is slowing” and “conditions in financial markets have generally improved,” the Fed’s Open Market Committee said in a June 24 statement after a two-day meeting in Washington, where it kept the target interest rate for loans between banks between zero and 0.25 percent.

With little need for the safety of government debt, Treasuries lost 4.5 percent in the first half as some of the biggest yields on corporate bonds in at least a dozen years lured investors. The S&P 500 Index gained 3.2 percent, including dividends.

While credit spreads are narrowing, defaults continue to rise. The U.S. speculative-grade default rate jumped to 8.1 percent in May, the highest since October 2002, and may reach 14.3 percent by the first quarter of 2010, according to S&P.

“The easy money has been made,” said Richard Lee, a managing director in the fixed-income trading department of closely held broker-dealer Wall Street Access in New York. “You could have bought any corporate credit in January and February and made out like a bandit.”

Greenspan’s ‘Normal’

Other measures of credit also show improvement. The difference between what banks and the U.S. government pay to borrow for three months, the TED spread, has shrunk to 42 basis points, about the lowest since July 2007 and down from 464 basis points in October. A basis point is 0.01 percentage point.

The Libor-OIS spread, an indicator for banks’ willingness to lend, fell to 0.36 percentage point today. That’s approaching the 0.25 percentage point that former Fed Chairman Alan Greenspan has said would indicate that markets were back to “normal.”

The increased demand has helped companies raise a record amount of money selling debt. Sales of corporate bonds surged 26 percent to $741.3 billion in the first half, compared with the same period of 2008, according to data compiled by Bloomberg.

New York-based Pfizer Inc., the world’s largest drugmaker, raised $13.5 billion on March 17 in the biggest bond sale by a U.S. company as part of its fundraising to buy rival Wyeth, Bloomberg data show. Redmond, Washington-based Microsoft Corp., the world’s biggest software maker, sold $3.75 billion of debt on May 11 in its debut offering.

‘Gigantic’ Returns

The commercial paper market has slumped the most ever as borrowers let the short-term debt mature or replace it with bonds. Unsecured commercial paper outstanding plunged 31 percent to $1.15 trillion, the lowest level since September 1998, according to Fed data.

“I have been buying credit the whole year,” said Gregory Nassour, who helps oversee $36 billion as head of investment- grade portfolio management at Vanguard Group in Valley Forge, Pennsylvania. “The excess returns are gigantic.”

To contact the reporters on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net; Cristina Alesci in New York at calesci2@bloomberg.net

Last Updated: July 1, 2009 15:38 EDT