SINGAPORE, July 27 (Reuters) - Asian shares dropped sharply while Japanese government bonds and the yen rose on Friday as investors fled riskier assets, fearing rising costs of corporate credit will damage the U.S. economy.

European shares were set for a battering after they suffered their biggest daily loss in five months on Thursday.

Bookmakers in London expect UK's FTSE 100 index to open down 33 to 39 points, Germany's DAX down 35 to 48 points and France's CAC 40 down 20 to 30 points.

The yen hit a three-month high against the dollar as investors, rattled by weak U.S. housing data and problems in credit markets, rushed to buy back the Japanese currency they had borrowed to finance purchases of higher-yielding assets.

The yen hit 118.02 per dollar in early trade but had dropped to around 118.60 by 0630 GMT as some Japanese investors started buying the dollar again.

Japan's Nikkei stock average fell 2.4 percent to close at a three-month low after Thursday's 0.9 percent decline.

Sony Corp. was among the few which bucked the trend, gaining 1.1 percent after its results beat expectations.

Other stock markets in the region also tracked overnight losses on Wall Street, which suffered its worst drop since the last global sell-off on Feb. 27.

PUNCH DRUNK

The VIX index, a measure of volatility, spiked to its highest level since June last year in U.S. trading.

"We might see a rebound but it's going to be like one of those boxers trying to get up after being knocked down," said Lim Chang-gue, a fund manager at Samsung Investment Trust Management.

"The long-term outlook for stocks is still positive, but right now investors are shifting into less risky assets, and who knows when that will be reversed."

MSCI's index of Asia Pacific stocks excluding Japan fell 3.4 percent, moving further away from a record high hit just earlier this week on the back of strong earnings and solid economic growth across the region.

South Korean stocks suffered their biggest one-day drop in three years and Taiwan's fall was the sharpest in over a year, with both markets closing down more than 4 percent.

Shares in Hong Kong fell 2.7 percent, Australian stocks dropped 2.8 percent and Singapore slipped 3.1 percent.

MORE WEAKNESS

Stocks around the globe fell on more signs of deterioration in the U.S. housing market and problems in financing corporate takeovers as debt costs spiked up for many corporate borrowers.

U.S. new home sales fell sharply in June and prices slumped, highlighting the weakness in the housing sector.

Trouble in U.S. subprime mortgage market led to a tightening of credit for corporate borrowers.

The iTraxx Crossover index, the barometer of European credit market sentiment, widened 10 basis points on Friday to 415 basis points, more than double the level in mid-June.

The flight to quality buoyed safer government debt and Japanese bond futures jumped to a two-month high, tracking an overnight rally in U.S. Treasuries.

In the currency market, the euro edged back to 163.50 yen after hitting its lowest level against the Japanese currency since mid-June and traded at around $1.3730 against the dollar, off an all-time high $1.3853 reached earlier this week.

Dealers said investors will wait for U.S. economic growth data later on Friday for the second quarter for further near-term direction.

Gold, another safe-haven investment, failed to capitalise on the rush to safety, hitting a two-week low in nervous New York trade ahead of an options expiry. It pared some of the losses in Asian trade.

Fears that weak U.S. housing market may hurt consumer spending and sap overall demand knocked more than $1 off oil prices in U.S. trade. But crude trimmed losses on Friday as market attention shifted back to worries over oil stockpiles.

U.S. crude for September delivery rose 25 cents to $75.21 a barrel by 0620 GMT and London Brent was up 22 cents at $75.40.

(Additional reporting by Rafael Nam in Seoul)