Everyone knows the challenges that state and local governments face right now. But prices in the municipal bond market have been beaten down to the point where their yields make no sense -- and smart investors are starting to look for opportunity.

The next bond crisis?
Investors have good reasons to hate muni bonds. State and local governments have struggled under the weight of huge budget deficits even despite the huge amounts of federal aid they've received under stimulus programs over the past few years. High levels of unemployment not only have put unprecedented pressure on state-funded social programs but also have reduced the amount of revenue states receive in taxes.

Municipal bond defaults have only happened on very rare occasions, explaining why fear in the muni bond market hasn't been even more extreme. But research analyst Meredith Whitney recently made headlines by predicting that between 50 and 100 bond defaults could occur in 2011 alone, potentially putting hundreds of billions of dollars at risk.

For a market that's traditionally been among the quietest backwaters of the financial markets, predictions of impending doom are a big change. Investors have made a mass exodus from the muni bond market, and prices have dropped sharply as a result. Now, though, prices have fallen so far that traditional relationships within the bond markets are starting to break.

Understanding muni rates
As with any bond, when the price of a given bond falls, the yield to maturity for investors buying the bonds on the secondary market goes up. So the drop in muni bond prices has hurt investors who already own the bonds, but it has also made those bonds more attractive for those on the sidelines.

The primary benefit for investors in muni bonds is that the income most munis pay is free of federal tax. For someone in the top 35% tax bracket, avoiding that tax is a huge boon. Because of that tax advantage, muni bonds usually yield less than taxable bonds. That way, once you take the tax benefit into account, their after-tax returns look similar.

But lately, muni bond rates have actually started to be larger than the yields on taxable bonds, even before taking the tax benefits into account. According to a recent report in Barron's, national munis with high bond ratings offer yields between 105% and 108% of comparable Treasury bonds -- and that's on a pre-tax basis.

And although one could argue that munis might conceivably be that much riskier than Treasuries right now, another discrepancy isn't as easy to explain away. Industrial revenue development bonds (IRDBs), which local governments issue on behalf of private companies to finance projects that are important to the government in question, have the same credit risk as regular corporate bonds issued by the same private companies. Yet certain IRDBs issued by Dow Chemical (NYSE: DOW), International Paper (NYSE: IP), and FedEx (NYSE: FDX) have higher yields than their regular corporate debt in the secondary market. So if you're an investor in those companies' bonds, you have to ask yourself: is there any reason to pass up higher yields with the bonus of being tax-free?

Getting on board
For those in high tax brackets, the rewards of muni bonds may well outweigh the risks. To take advantage, you have a number of options. The iShares S&P National AMT-Free Muni Bond ETF (NYSE: MUB) and PowerShares National Muni Bond ETF (NYSE: PZA) own a wide range of muni bonds from around the country. If you want state-specific bonds in order to get a local tax break as well, then closed-end funds are worth looking at. Closed-ends Nuveen New York Quality Income Muni (NYSE: NUN) and Blackrock MuniYield California Insured (NYSE: MCA) have distribution rates of 6% to 7% and trade at discounts to their net asset values. That gives you a built-in margin of safety from the start.

Before you buy, though, remember that when rates are out of equilibrium, one of two things can happen. Munis could recover, but the alternative is that Treasuries and other types of bonds could fall in price down to the level where current muni yields would suddenly make sense again. Betting on munis is far from a sure thing, but with almost universal hatred for them, you should definitely take a closer look.

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