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Google 'Minsky moment' before buying these bonds

IN just a few months, a shunned corner of China's US$13 trillion bond market has become an investor favourite. Thank the trade war.

Local government financing vehicles (LGFV) have long been seen as the potential trigger for a Minsky moment, a sudden crisis that follows a buildup of debt. As recently as October, there was little appetite for their bonds in the offshore dollar market. These days, millions are being raised by first-time issuers from cities so obscure that most people would need Google to find out where they are.

This remarkable turnaround in sentiment reflects investor bets that Beijing won't let LGFVs default, at least for a while. As trade tensions with the US intensify, China can't afford to alienate the bond market. With the government back in stimulus mode, it needs such sales to finance infrastructure projects that will help to keep the economy growing.

China is notorious for pushing the dirty work of stimulus on to local governments that lack sufficient sources of income. They use debt to plug the gap. A spending spree in 2012 resulted in almost 30 trillion yuan (S$6 trillion) of LGFV obligations. In the past three years, China amassed another 8.1 trillion yuan of special-purpose municipal bonds, Beijing's new favourite tool for project financing.

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Despite a spate of default scares involving state-owned enterprises and investment conglomerates, no municipality or LGFV has reneged on its bond obligations. Yields are also alluring: Provincial LGFV debt can pay 5 per cent or more.

In their enthusiasm, investors haven't necessarily lost the ability to discriminate. Provinces with high ratios of LGFV bonds to GDP are paying more to borrow, a Bloomberg News analysis showed on Tuesday.

This makes sense, as far as it goes. What's missing, however, is how much we know about these structurally opaque vehicles, which are essentially shell companies set up by municipalities to finance off-budget projects, and how much corporate-governance risk they entail.

Earlier this month, bonds of Yunnan Energy Investment Overseas Finance Co fell after reported that the company was embroiled in a legal battle with CEFC China Energy Co, an energy trader that defaulted on a series of bond payments last year. The dispute centres on financing of a venture between the two companies, according to the Chinese media outlet.

Nasty discoveries can be made when things go sour with government-linked entities. Qinghai Provincial Investment Group Co was long considered an LGFV by bond investors. When the aluminium maker missed a coupon payment in February, doubt surfaced as to its exact nature.

The company was 69 per cent-owned by the Qinghai State-owned Assets Supervision & Administration Commission, the government body that supervises state-owned enterprises, according to HSBC Holdings plc. As a result, "we consider the group a local SOE", the bank wrote in a report.

That changed the calculation entirely: China allowed SOEs to go bust as early as 2015. This saga, at least, had a happy ending: Qinghai Provincial paid its dollar bond coupon by the end of February and its bonds recovered from their plunge.

Investors have long looked at provincial governments' finances, but a stream of new issuers will soon force them to investigate at a more granular level. Do you know where Huzhou, Yichang, Yangzhou or Zhuzhou are, or what their governments' books look like?

Yichang Gaoxin Investment Development Co, from the second-largest city in central Hubei province, issued a US$150 million dollar bond in April, as yield-thirsty foreigners clamored for its 7.5 per cent coupon. Some, such as BlackRock Inc, settled for 4.5 per cent.

To beat benchmarks, bond-fund managers may have no choice but to buy high-yielding Chinese local government debt. They need to recognise they're in uncharted waters, though. A good geography lesson is in order.