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 investigated by the Financial Services Authority (FSA), 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 a "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 to £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. 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.

Pension funds have 43.2 per cent in government and company bonds, compared with 38.5 per cent of their money in shares. This is a reversal of the balance a one year ago.