Analysts said the situation convinced the National Development and Reform Commission, the top economic planner and regulator of State-owned enterprises' bond issues, to ease the rules in late May. To deter China's 10,000-plus LGFVs from indulging in their insatiable urge to borrow, the NDRC earlier imposed limits on bond issues such as annual ceilings. These requirements were quietly eased a couple of weeks ago.

At least three Chinese brokerages forecast that the supply of new LGFV notes will surge later this year. China International Capital Corp said that because it takes about two months for issuers to prepare filings, the effect of the NDRC easing would not be seen until the third quarter.

The dearth of fresh supply has made the increasingly rare legacy bonds more appealing to investors.

"Municipal bond yields aren't attractive for funds," Zhang Xue, a fund manager at Morgan Stanley Huaxin Fund Management Co, told Bloomberg News. "If everyone thinks there's an implicit guarantee over these LGFV bonds and credit risks aren't high, there'll still be demand."

A seven-year AA-rated LGFV bond from Jiangxi was issued in late May at a 5.5 percent coupon, the lowest among similar bonds issued this year, showing the product's popularity.

However, the NDRC easing does not mean a return to "business as usual" situation that prevailed before the document in October.

The NDRC document specified that new bonds from LGFVs cannot be regarded as "government debt", meaning they cannot be repaid from the official budget. A line was drawn between corporate credit and government credit, at least in theory.

That was a step toward a recent International Monetary Fund call for China to break "the web of implicit guarantees" and strengthen corporate governance among SOEs. But reality in China is far more complicated.

"If the bonds that aren't included in the official budget run into repayment difficulties, it'll signal the beginning of local-government defaults," Xu Gao, an economist at Everbright Securities Co, said. "Investors will abandon all local-government debt, causing a systemic financial crisis."

Financial analysts said there was little chance that the government would let that happen.

A report by Industrial Securities Co Ltd said that compared with high-rated LGFV bonds, lower-rated ones are viewed more favorably because they are thought to enjoy implicit guarantees. Old bonds are safer because they are more likely to be categorized as "government debt".

Zhou Yue, an analyst with China Merchants Bank Co Ltd, said that investors will increasingly have to evaluate credit risk on individual bond basis.

Zhou said that while municipal bonds will finance most public projects that do not offer high returns, such as water, bus services and subsidized housing, LGFV bonds will still be necessary to fund infrastructure projects such as toll roads and industrial zones.

For the time being, it seems, the two types of debt will co-exist.