We've come to expect the Federal Reserve to ride to the rescue and shore up financial markets. But yesterday, similar help came from an unusual source: the Supreme Court.

In an important decision that motivated seven of the justices to write their own opinions, the high court upheld the right of the state of Kentucky to continue offering state income tax incentives to investors who buy municipal bonds issued in Kentucky.

Although the court has held that the U.S. Constitution prevents states from creating barriers to interstate commerce, the seven justices agreed that that restriction did not apply to municipal bonds.

Another large market
At first glance, the Supreme Court's decision may not seem as important to financial markets as the Fed's backing of JPMorgan Chase (NYSE: JPM) in its buyout of Bear Stearns (NYSE: BSC).

At $2.5 trillion, however, the municipal bond market has become huge in its own right. Conservative investors flock to muni bonds to earn interest that's free of taxes, both at the federal level and, often, from states as well. If the Supreme Court had made its decision the other way, moreover, investors far beyond the muni bond realm would have felt the impact.

What was at stake
The case didn't deal with the federal tax exemption for muni bond interest, which is specifically incorporated into the Internal Revenue Code. Instead, it focuses on how individual states deal with municipal bonds -- both from within and outside their borders.

This case arose when two Kentucky taxpayers argued that all of their interest from muni bonds should be exempt from Kentucky income tax, regardless of where they were issued. Kentucky law, however, stated that while income from muni bonds issued within Kentucky was free of tax, interest on bonds from other states didn't get an exemption at the state level. A state appeals court had agreed with the taxpayers, leading to the appeal to the Supreme Court.

Had the decision gone the other way, it would likely have roiled the municipal bond market. States would likely have concluded that if they couldn't collect taxes just on muni bonds issued out-of-state, they'd have to get rid of the interest exemption entirely. That would've instantly led to higher interest rates, lowering the value of muni bonds in high-tax states. Bond fund shares -- especially those of the more than $150 billion in funds that focus on bonds from single states -- could have suffered a huge drop as a result.

Broader economic impact
A muni-bond market disruption would have hit Wall Street profits. If fewer muni bonds were issued, then top underwriters like Citigroup (NYSE: C), Merrill Lynch (NYSE: MER), and Morgan Stanley (NYSE: MS) would have seen a sizable segment of their business evaporate.

Also, some fund management companies would've taken it on the chin. Firms like Nuveen Investments, BlackRock (NYSE: BLK), and the PIMCO division of Allianz (NYSE: AZ), have quite a few muni-bond funds, including single-state funds. Anything that spooked investors would likely create big fund outflows, reducing revenues.

But the pain wouldn't have stopped there. Higher costs to borrow money might well have discouraged cash-strapped states and cities from issuing as many municipal bonds, instead choosing to cut back on construction and infrastructure projects. These government projects are crucial to the local economy in many areas, providing a much-needed inflow of money from outside the community that provides jobs and supports businesses. In an already weak economy, that's the last thing anyone needs right now.

See if munis are right for you
With the Supreme Court's decision, though, the municipal bond market has one worry taken off its shoulders. Although other economic factors, such as falling home prices and local tax revenue, are still a concern, municipal bonds are still a useful, tax-smart investment for many investors.

To learn more about municipal bonds and to see if they might be right for you, consider taking a look at our Champion Funds newsletter. Inside, you'll find several articles on muni-bond funds from our archive of past issues, along with our current fund recommendations and analysis. A complementary 30-day pass is yours for the taking.

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