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Photographer: Qilai Shen/Bloomberg Photographer: Qilai Shen/Bloomberg

The latest bond failure by a Chinese local government investment arm has rekindled concerns about a group of borrowers whose outlook is closely tied to Beijing’s shifting definition of its implicit backing.

The debt woes faced by Hohhot Economic & Technological Development Zone Investment Development Group, a local government financing vehicle from Inner Mongolia, have sent chills among investors holding other such LGFV bonds, driving prices sharply lower for some.

The development also came just as onshore corporate bond defaults in China rose to a record high this year as the worst economic slowdown in three decades constrains Beijing’s ability to bailout failing borrowers.

Companies such as the LGFV from Hohhot have until now emerged as major beneficiaries of the surge in defaults as investors feared debt from ailing private businesses and on expectations that Beijing wouldn’t let these government-linked firms ever go bust.

The borrower, which is from one of China’s poorest regions, missed repaying principal on 1 billion yuan ($142 million), five-year privately placed note on Friday after investors exercised a put option on the paper, according to research notes by several Chinese brokerages published Saturday.

Research notes from Guotai Junan Securities Co., Guosheng Securities Co., and Southwest Securities Co. attributed the information to a statement by the Shanghai Clearing House dated Friday that was sent to bondholders.

The issuer has a 10-day grace period to make good on the debt obligations, according to a bond issuance prospectus seen by Bloomberg. Failure to do so would make it the first LGFV bond default in China.

Calls to the bond issuer went unanswered while the clearing house declined to comment on the matter. Given that the note was privately placed with select institutional investors, information related to it isn’t usually made public.

Record Defaults China's onshore company bond defaults hit new high Source: Bloomberg

Regional governments in China have long used LGFVs to raise funds via off-balance-sheet debt. Without formal state backing, Beijing’s shifting attitude over the years has dictated their fortunes: after years of lax oversight, Beijing placed restrictions on debt issuance by LGFVs in 2014 to cut financial risk, only to ease those later as the economy started slowing.

The outstanding value of yuan-denominated bonds sold by LGFVs now totals 8.3 trillion yuan, according to data compiled by Bloomberg. Outstanding value of offshore notes from such entities is around $71.5 billion.

A dollar note due 2020 issued by Inner Mongolia High-Grade High Way Construction and Development Co., another LGFV in the same region, saw its dollar bond spread widen to the most in two months after the the news of payment woes at the Hohhot firm.

“Hohhot government may be prompted to raise money with all efforts so as to prevent a single debt failure from becoming a financial crisis in the region,” according to a research note by Southwest Securities written by analysts including Yang Yewei. “If an actual default occurs, the incident may trigger a selloff on bonds sold by lower-rated LGFVs on the short run.”

A similar incident last year had briefly jolted China’s bond market.

Xinjiang Production Construction 6th Shi State-owned Assets Management, a cotton trader owned by the local government, missed interest and principal on a 500 million yuan, before making good on the delayed repayment a few days later.

Analysts at Guotai Junan and Guosheng Securities expect the Hohhot LGFV to resolve the crisis with help from local authorities, as Beijing can’t afford to let any bond default by opaque government entities to set off a time bomb in China’s creaky financial system.

China’s leaders vowed to avoid systemic financial risks next year and keep growth in a “reasonable range,” state-run Xinhua News Agency reported, citing a Poliburo meeting in Beijing on Friday.

The Hohhot LGFV is rated AA by Golden Credit Rating International Co., a level seen as sub-investment grade in the domestic market.

— With assistance by Tongjian Dong, Hong Shen, Yuling Yang, and Molly Dai

( Updates with onshore bond defaults hitting a record high in third paragraph. )