Billions of pounds invested by pension funds, City institutions and retail investors could be hit by a looming "armageddon" in the bond markets, it emerged yesterday.
Experts warned that a bubble is building in the £250bn corporate bond sector, which has become a popular way to invest because it offers safer returns than most traditional savings and investment products.
According to industry figures, 40 per cent of assets in the market are owned by five large funds and 30 per cent by the three largest. Fears have been raised that these funds could struggle to meet investors' demands to withdraw money because of illiquidity in the market.
The issue, which is being looked at by the Financial Services Authority, has been raised by Old Mutual Global Investors in a note to clients seen by The Independent.
Stewart Cowley, head of fixed income at the fund manager, warned of "liquidity crisis" in the market. He said rival M&G has asked advisers to stop putting money in its corporate bond funds, while Invesco has said it needs to keep £750m in cash and short-term securities as a liquidity buffer.
"Let's look at a hypothetical situation such as the FSA might be concerned about, for example, if a manager at one of the mega-funds was to retire and a proportion of the investors in the fund wished to redeem their positions until a new manager had settled in," he said. "Let's suppose the effect was a modest run of redemptions equal to 5 per cent of the fund. In a fund of £6bn, that is £300m. This would be extremely difficult to liquidate in a market which trades in parcels of £1m-£2m, and where the counterparties are your direct competitors."
One City source said the large inflows for these "mega-funds" meant the quality of bonds being bought could also be hit. In order to soak up their cash flows, mega-funds managers need to buy most of the bonds available, not just the best-value bonds.
Simon Evan-Cook, investment manager at Premier Asset Management, added: "Getting caught in an illiquid asset class when the herd decides it's time to bail out could incur permanent losses for investors. It's crucial to avoid funds that have grown too big for their asset class, as they can leave you low and dry."
Talk of a corporate bond crisis is likely to make grim reading for UK pension funds, which have seen their deficits widen in recent years. Earlier this month, figures from the Pensions Regulator and Pension Protection Fund showed that pension schemes now have more of their money invested in bonds than in shares.
Pension funds now have 43.2 per cent in government and company bonds, compared with 38.5 per cent of their money in shares. One year ago, the balance was tipped the other way, with investments in shares at 41.1 per cent compared with 40.1 per cent in bonds.
Roger Mattingly, president of the Society of Pension Consultants, said: "Given their size, pension funds would be amongst those hardest hit if the risk of a destabilised bond market was realised.
"Managing liabilities and risk is the challenge facing every pension fund and these are inextricably linked.
"In their efforts to manage their liabilities, investors need to make sure that they take into account all the risks, some of which are not always immediately apparent and some of which can even be created by trying to do the right thing."