After living through the most recent financial crisis, a lot of folks have their eyes peeled for the next big catastrophe. We're not totally out of the woods yet, so it's not surprising many investors are waiting for the other shoe to drop. And it doesn't take too much detective work to see where a lot of people think the next big problem will arise.

Danger ahead
A combination of falling tax revenues and unsustainable levels of spending are leaving many state and local governments in the lurch. Fear of an increase in possible defaults has roiled the municipal bond market in recent months, driving up average muni yields to nearly 5.4% as of Jan. 20, the highest since the worst days of the financial crisis back in December 2008. Perpetually indebted California faces a budget shortfall of roughly $25 billion this year, and some are even predicting default for the Golden State. Many other states face similar challenges and a lot of investors aren't waiting around to see how things will shake out -- in fact, they've been abandoning muni bonds en masse in recent weeks.

Last year, Warren Buffett himself warned that there is a "terrible problem" looming for the municipal bond market. Analyst Meredith Whitney, who earned fame for correctly predicting that Citibank would have to cut its dividend to survive, has made some pretty dire predictions about the sector. She is forecasting 50 to 100 significant municipal bond defaults this year, totaling hundreds of billions of dollars. If her prediction is even partially accurate, that would mean muni bond investors would take a huge hit.

A reasoned approach
While I don't want to make light of the serious problems that many state and major municipalities are facing right now, I just don't see a massive crisis looming ahead. There may in fact be some defaults in the coming quarters, but I don't think we're going to see anything that constitutes a crisis. Muni bond defaults are incredibly rare. According to Forbes, last year there were only six municipal bankruptcies, five of which were for rather small dollar amounts. Furthermore, from 1999 to 2009, only 10 entities are on record as having failed to make debt-service payments, according to Fitch Ratings. Of course, just because mass defaults haven't happened in the past doesn't preclude them from happening in the future. But states have the ability to cut spending and raise taxes to help service debt payments, making mass defaults unlikely.

In fact, given where yields are right now, muni bonds may be even more attractive now for higher tax-bracket investors. Investors have pulled massive amounts of money from the sector in recent weeks, driving prices down and yields up. If default fears prove to be overblown, this could be an opportune time to buy. Bond luminary Bill Gross has gone on record contradicting Whitney's call, saying that while there may be some defaults, he doesn't believe there will be that many of them. According to Gross, "The bottom line is that sky-is-falling reports about the muni market are lacking in evidence." Revenues have begun to climb again as the nation's economy emerges from recession, helping to boost states' coffers. States will undoubtedly need to make painful cuts in spending to make ends meet, but I think investors who are abandoning the muni bond market may end up hurting themselves in the long-run.

Where others fear to tread
Risks will remain elevating in this sector for some time to come, so if you are thinking about dipping your toes in the water here, there are a few things to keep in mind. First of all, take a diversified approach. Since so many states and municipalities are facing increased pressure, you want to spread your bets around to avoid the impact of any potential defaults. This means a muni bond mutual fund or exchange-traded fund is your best bet right now. Here are some ideas:

  • Several national muni bond ETFs fit the bill for general use, including PIMCO Intermediate Muni Bond Strategy ETF (NYSE: MUNI) or Market Vectors Intermediate Muni ETF (NYSE: ITM).
  • For those looking for longer-duration bonds, which could gain more if muni bond rates start falling again, iShares S&P National AMT-Free Muni Bond ETF (NYSE: MUB) might also work for some investors.
  • On the other hand, if you want a more conservative fund that focuses more on the shorter side, SPDR Nuveen Barclays Capital Short-Term Muni Bond ETF (NYSE: SHM) is a good pick.
  • People in high-tax states can benefit from state-specific funds. Investors residing in New York or California might want to consider iShares S&P NY AMT-Free Municipal Bond (NYSE: NYF) or iShares S&P CA AMT-Free Municipal Bond (NYSE: CMF), respectively.

Next, keep a focus on higher-quality issues. Now may not be the time to dive into high-yield municipal bonds, so stick with funds that have an investment-grade (rated BBB or above) average credit quality. On the actively managed fund side, Vanguard Intermediate-Term Tax-Exempt (VWITX) boasts an average AA credit quality rating, while American Century Intermediate-Term Tax-Free Bond (TWTIX) clocks in with an A rating . Both funds have fine long-term track records and reasonable expenses for the asset class.

There will undoubtedly be tough times ahead for local and state governments, which will likely flow over into the muni market. However, be careful not to get caught up in the panic and flee this corner of the market if investing in muni bonds makes sense for you. If the U.S. economy manages to right itself, municipal bonds could become a much more attractive proposition.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Try any of our Foolish newsletter services free for 30 days.

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