Fears for corporate bond investors

Corporate bond funds are on most investors shopping list. They are meant to be safer than shares, investing in some of the world's biggest companies and achieving a regular income stream. No wonder that in June more than £200m were ploughed into this type of fund.

But there are growing concerns that investors' faith in these funds as an uber-safe haven could be misplaced.

The problem seems to be, according to the Financial Services Authority, one of liquidity. Instead of investors being able to withdraw their cash, there are concerns that in the future, they might not be able to access it or find that, if they can, a significant value has been lost.

So concerned is the FSA with these risks it has written to corporate bond fund managers, to see if they can meet investors' requests to withdraw money. The question, then, is should you be thinking of other ways to get an income, rather than relying on funds where you could be trapped?

"The FSA is absolutely correct to be concerned," says Peter Sleep at Seven Investment Management. He warns that if the market began to fall, investors may rush for the exit and corporate bond funds may not be able to raise enough cash to pay them back. "This has happened in the recent past with property funds, many of which closed or imposed penalties on investors wishing to sell," Mr Sleep says.

Some of these funds are very large, running into many billions of pounds. "Fund size is a crucial factor," says Rob Morgan at Hargreaves Lansdown. "A small fund should be able to buy and sell fairly easily whereas it's more challenging for a larger fund."

He adds that we may not be far away from seeing a number of funds trying to reduce incoming money. But even bond fund managers admit the ability to buy and sell corporate bonds without affecting prices – the level of "liquidity" – is bad. "Anyone who says liquidity is not a problem is lying," said Richard Hodges, the bond fund manager at L&G Investment Management.

James Foster, a bond fund manager at Artemis, also believes the FSA is right to be concerned. He says five years ago, investment banks would have happily bought the bonds, but now they are circumspect about taking this kind of risk on.

"Should investors look to sell, then the investment banks won't be there to absorb the selling," says Mr Foster. "Prices could then move with much greater volatility, falling sharply to reflect the selling pressure."

Mr Foster adds these issues could push investors to look more to equity funds in order to generate an income, although these are not without risks. "The yields on many equity income funds are not far off corporate e bonds and in many situations higher," says Mr Foster.

But equity income funds – which invest in firms which the manager reckons will pay a consistent dividend – is not without risk.

If the corporate bond market falls, it is highly likely the equity market will fall more, warns Mr Sleep. "Many of the companies in a corporate bond fund will also feature in an equity income fund," says Mr Sleep. "Whatever causes a sell-off in the corporate bond market, whether it is an economic, political or some other shock, will likely cause a sell-off in the equity market. Our advice, as always, is to remain diversified."

Emma Dunkley is a reporter for citywire.co.uk