Taiwan's Securities and Futures Commission is quietly discouraging fund managers from launching new bond funds, according to several sources in Taipei. One fund manager believes the SFC is telling firms it will no longer approve applications for new bond funds; SFC officials deny that, but acknowledge they are concerned about the explosion of these funds in a market where the supply of high-quality debt is small.

The regulators are said to be concerned that some domestic houses are ramping up their assets under management and creating a bubble. Some players speculate this is a play to make these businesses look attractive to potential foreign acquirers, but at the risk of investing increasing amounts in low-quality corporate debt, putting them in danger of default situations.

The investment culture, such as it is in Taiwan, has always been heavily weighted toward bond funds, usually short-term ones, because interest rates have traditionally been high, equities volatile, and capital gains on bonds tax-free. Lately a gap has opened between the yield on bank time deposits, which have fallen to around 3.2% on a three-month deposit (before tax) and short-term bond funds, which have a yield up to 4.5% (tax free).

Fund managers with a securities investment trust enterprise (SITE) license have kept bond fund yields high in order to attract assets. Such is the frenzy for these returns that many investors are now borrowing money from banks to invest in bond funds, an arbitrage encouraged by SITEs, some of which have experienced asset growth of up to NT$10 billion this year in fixed-income AUM, according to the Securities Investment Trust & Consulting Association.

Some foreign players believe these firms' parents may be interested in fattening them up for selling. The past year and a half have seen foreigners such as ABN Amro Asset Management, HSBC Asset Management and Invesco buy local SITE companies at plump premiums.

But credit quality in Taiwan is deteriorating, and more bond funds means they are forced to buy further down the credit curve. Fund managers believe the SFC is concerned that these bond funds are full of bad debt, putting these SITEs at risk of going under - and leaving a lot of angry investors out of pocket, who will no doubt demand a government bailout. "It's a big monster that's grown out of control," says one observer.

Foreign fund managers are happy that the SFC is putting an end to the charade, and believe this is one part of an overall effort to professionalize the market. "This is a good step, it means tighter control," says one. "The SFC wants to upgrade the industry and there have been many abuses related to bonds."