China’s government-linked corporate bond market works a bit like a strapless bra. Every once in a while, things might fall a bit out of place, but buyers still trust the underwire to stay put. 

This year, as officials crack down on shadow banking, traders have been flooding into the haven of state-owned enterprises. Particularly popular are notes issued by off-balance-sheet shell companies set up by municipalities, which often fund local infrastructure projects. These bonds typically offer higher coupons than traditional municipal debt — and, more importantly, Beijing hasn’t allowed a single delinquency in the $1.2 trillion of bonds outstanding. 

So far, betting on the state has paid off. While China’s corporate bond defaults hit another record high this year, most came from borrowers in the private sector.

But last week, two events shook traders’ faith. A local government financing vehicle in Inner Mongolia, Hohhot Economic & Technological Development Zone Investment Development Group, didn’t repay the principal on a 1 billion yuan ($142.1 million) note. Meanwhile, state-linked Peking University Founder Group Corp. missed a payment on a 2 billion yuan bond. 

Traders went cross-eyed. Is Beijing’s implicit guarantee broken? Is it time to re-examine who makes the cut? 

When it comes to state-linked entities, we need to think about their function and how crucial that is to the government. These factors matter a lot more to Beijing than traditional credit metrics like cash flows.

Hohhot, for instance, mainly provides public services, from solar farming to waste-water treatment. That may just be its saving grace. On Monday, after coughing up some money and promising the rest by early March, the LGFV argued that last week’s event was merely a technical default. The company said its “former main leader” was under investigation and, as a result, some assets were frozen. Sure, financing remains tight, but chances are Beijing will find a way to fund the impoverished province of Inner Mongolia and pay investors back. 

Founder, on the other hand, is entirely different. Established in the early 1990s as a high-tech firm, the subsidiary of the prestigious university has expanded into every business imaginable. Finance and real estate now account for the bulk of its profit, while commodity trading comprises most of its sales. So when fiscal budgets are tight, it won’t be difficult for Beijing to let Founder go. It’s providing neither a social service nor investing in nationally strategic fields, such as chip design or artificial intelligence. 

To make matters worse, Founder’s state links aren’t entirely clear, as a legal tussle unfolds over its ownership. If courts determine that company control rests in the hands of a trio of private investors, rather than a public institution, many brokers and traders will get caught flat-footed. Founder would be one of the biggest corporate defaults in China: It has 23 onshore notes outstanding, with two-thirds, or 24 billion yuan, due over the next year.

In President Xi Jinping’s China, reining in financial risk has become synonymous with restricting lending to private businesses. That’s why betting on state-affiliated entities is still a smart move. After all, why would Beijing cause unnecessary market jitters and close an important funding channel? But not all government-linked entities are created equal. It’s time to weed out the low-quality “fakes.” 

To contact the author of this story: Shuli Ren at sren38@bloomberg.net

To contact the editor responsible for this story: Rachel Rosenthal at rrosenthal21@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron’s, following a career as an investment banker, and is a CFA charterholder.

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