Japan's Nikkei share average plunged 10.6 percent on Tuesday, posting the worst two-day rout since 1987, as hedge funds bailed out after reports of rising radiation near Tokyo. Many mutual funds were left on the sidelines, leaving them poised to dump shares into any rebound.

The yen tripped on talk of intervention by authorities trying to contain the economic impact from last week's devastating earthquake and tsunami, but then recovered. Government bond yields rose as investors sold debt to offset stock market losses.

The scale and speed of the equity selloff forced domestic fund managers to sit on the sidelines as market volumes surged to a record for a second day running.

Even if we wanted to sell today there was very little we could do, said a manager at a Japanese fund, asking not to be named because he was not authorized to speak to the media.

We didn't sell and waited, sidelined because hedge funds were just dumping stocks in panic.

At one point, the Nikkei had plunged 14 percent after Prime Minister Naoto Kan said the risk of nuclear contamination was rising at the Fukushima Daiichi complex on Japan's quake ravaged northeastern coast, 240 km (150 miles) north of Tokyo. The French embassy said low-level radiation could hit Tokyo within hours.

Local reports of radiation rising in communities near Tokyo only stoked the sense of panic.

In contrast to Monday's trading, when construction stocks rose in anticipation of revenue from rebuilding contracts, none of the 225 constituents of the benchmark Nikkei average gained on Tuesday. Shares of construction company Kajima Corp <1812.T> slid 13 percent, a day after its shares surged.

The broad TOPIX index of Japanese stocks has shed 16.3 percent this week, the worst two-day losing streak since the global equity crash of October 1987.

All focus is on the nuclear crisis, said Hideyuki Ishiguro, a supervisor at Okasan Securities in Tokyo. Foreign investors and domestic fund operators are pulling out from Japanese shares.

The Nikkei share average <.N225> dropped 10.6 percent to 8,605.15, while the TOPIX share index lost 9.5 percent to 766.73 <.TOPX> -- both the worst single-day slides since the global selloff after the Lehman Brothers collapse in 2008.

The Tokyo Stock Exchange's first section, making up the country's biggest companies, has lost about $626 billion in market capitalization this week. First section volume totaled 5.77 billion shares, a nearly 20 percent increase from Monday's record.

Traders said overseas hedge funds were particularly aggressive sellers in Nikkei futures, especially the Singapore-listed contracts. The massive swings in futures sent implied volatility on Nikkei options soaring to 71 percent, the highest since the financial crisis.

During the first phase of the rout, many domestic portfolio managers sat on the sidelines to await more clarity on the nuclear troubles. But some investors threw in the towel on Tuesday.

Today's market moves truly show the severity of Japan's situation. It's a true market, it's not a lie or speculation. We're not talking any more about power cuts, earthquake or tsunami, we're talking about which areas will get most radioactive exposure, said the chief trader at a Japanese securities firm.

I had to sell, and I just dumped everything as I went along, the trader said.

Japanese officials tried to calm the market and moved to reduce short selling, placing limits on broker sales of stocks for arbitrage trading. That move helped spark a bout of short-covering in the afternoon, and stocks finished off their lows.

Shares of Tokyo Electric Power <9501.T>, the owner of the stricken nuclear plant, did not trade, although sellers massed at the indicated price of 1,221 yen on Tuesday. There were no buyers at that price.

The stock market rout was bad enough to force some institutional investors to sell government bonds to offset losses in their portfolios before Japan's business year ends this month, traders said.

Insurance companies were cited behind the selling in cash JGBs, pushing benchmark 10-year yields up a basis point to 1.215 percent. Longer-term yields were up even more.

The worries about the potential fiscal cost of the crisis and new bond issuance caused a further back-up in long-term yields. Twenty-year yields rose 4 basis points to 2.075 percent, causing the yield curve to steepen for a second day.

Since Friday's massive quake, market players have fretted that a hefty reconstruction bill will further add to Japan's debt totaling twice the size of the $5 trillion economy.

Japanese government CDS spreads have widened 38 basis points to 118 basis points, near the record 120 basis points reached in February 2009 and reflecting worries of more credit rating downgrades ahead.

Nikkei futures remained volatile in after-hours trade. After an initial bounce, Osaka Nikkei futures fell 2.6 percent from the regular session close to 8,420. Still, JGB futures gave up their gains and slid into negative territory.

The yen strengthened to 81.40 per dollar and was relatively stable given the scale of the equity market selloff.

Traders were on alert for signs that Japanese investors were repatriating funds, a phenomenon that had pushed up the yen in the wake of the 1995 Kobe earthquake.

At one point, the dollar spiked against the yen, and dealers suspected that Japanese authorities may have intervened in the market. They later downplayed the idea, with a large buying order cited as exaggerating the move in choppy trade.

The dollar had touched a low around 80.60 on Monday, less than a yen from the record low of 79.75 yen touched in 1995 on trading platform EBS.

Fund managers said the sheer uncertainty around the nuclear crisis and economic risks suggested it would take investors a while to feel confident about buying stocks.

We know where things are bad, but we don't know anything about sustained damages yet, so buying anything is a huge risk, said one fund manager in Tokyo.

(Additional reporting by Hideyuki Sano and Akiko Takeda in Tokyo, Masayuki Kitano in Singapore and Vikram Subhedar in Hong Kong, Writing by Kevin Plumberg, Graphics by Scott Barber and Catherine Trevethan, Editing by Eric Burroughs)