The Securities Association of China (SAC) on Friday banned primary bond funds from subscribing to equity initial public offerings, a method long used by asset managers to boost returns.

There are three categories of bond funds in China. Pure bond funds only invest in fixed income; primary bond funds could previously also invest in newly issued stocks; and secondary bond funds can invest in fixed income as well as stocks in the primary and secondary markets.

As of July 10, there were 146 open-ended bond funds in China, including 17 pure bond funds, 61 primary bond funds and 68 secondary bond funds.

The July 6 circular has effectively turned primary bond funds into pure bond funds. This is part of the broader reform initiated by the China Securities Regulatory Commission to address issues surrounding the IPO pricing mechanism. A-share IPOs have long been overpriced, leaving little upside for investors in secondary markets.

Primary bond fund managers have traditionally sought profits by subscribing to newly issued equities in the primary market and selling them in the secondary market, thereby boosting their returns. The CSRC has been seeking to crack down on this kind of short-term speculation.

Although IPO subscriptions often make a positive contribution to returns, primary bond funds have not always performed better than pure bond funds. In fact, they lagged far behind pure bond funds last year. The average return for pure bond funds was +1.5% in 2011 and for primary bond funds it was -2.33%, according to data from WindInfo.

“Since the volatility of bond markets is lower than that of equities, in order to boost short-term investment returns and achieve a higher ranking, fund managers often subscribe to IPOs, and some even see it as a must,” says Howbuy, a Shanghai-based consulting firm.

It further points out that an IPO subscription can be a double-edged sword. “In a bull market they can enhance investment returns, but when the market goes bearish they can also drag down fund performance.”

“It might be a good thing for bond fund managers not to engage in IPO subscriptions but to focus on their real job,” suggests Howbuy.

All that said, the SAC circular effectively changes the investment scope of primary bond funds by forcing them to breach the contracts their investors have agreed to.