The impending death of the tax-free bond market has been greatly exaggerated. By Jeffrey R. Kosnett, Senior Editor August 22, 2011 A year ago, legions of Americans would probably have bet the ranch, the SUV and the iPad that by now at least one state would have missed an interest payment to its bondholders or be negotiating to restructure its debt. Well, not only hasn’t that happened (not even in crisis-ridden California), it’s unlikely to happen soon. SEE ALSO: Our Video on How to Earn Higher Yields in a Low-Yield Market Some financial analysts and bloggers still expect a municipal bond apocalypse -- the flood of state and local defaults that gadfly analyst Meredith Whitney predicted last December would materialize by March. But in the tax-free bond market itself, which is what really counts, 2011 has so far been a time for opportunity rather than scaremongering. I don’t mean to suggest that state and local governments are having an easy time. Layoffs, furloughs, school budget cuts, missed road repairs and the like are rampant. Moreover, cutbacks could accelerate after 2011 as Uncle Sam reduces aid to state and local governments. But potholes in the streets do not cause potholes in the portfolios of municipal-bond investors. Advertisement Compared with the federal government -- which, of course, has its own printing press -- local finances look rosy. Interest payments in the latest federal budget represent 10% of revenues. But bond interest is a relatively minor item in state and local budgets, accounting for 2.7% of spending for the 50 states and 4% for localities. That nut is fairly easy to cover by raising taxes, which many localities are doing, and making assorted spending cuts. State and local governments are showing great resilience. Only 20 municipal bond issues that at one point had been evaluated by one of the rating agencies are in default; their face value is just $1.7 billion. Some 38 other rated bond issues (out of thousands), totaling $9.2 billion, have issued a notice of distress, which means the borrower hopes to liquidate or is making interest payments by borrowing from other lenders or raiding reserves earmarked for capital improvements. Clearly, the financial markets understand that these are isolated cases. Year-to-date through July 8, high-grade munis maturing in seven to 12 years returned a respectable 5.8%, says Bank of America Merrill Lynch. What If the USA Loses Its AAA? Some analysts worry about what would happen to the muni market if the federal government lost its coveted triple-A rating. Their concern is that many munis would be automatically downgraded because none could be rated higher than Uncle Sam. But one of the raters, Moody’s, says it could rate some muni issues a notch or two above government debt. The bonds that would be most vulnerable in the event U.S. debt were downgraded would be those secured by Treasuries held in escrow. They could lose value despite Uncle Sam’s backing. Advertisement But the U.S.’s budget problems might also help munis in unintended ways. Chris Mauro, head municipal strategist at RBC Capital Markets, expects that Congress and the White House will eventually hack away at the $50 billion that the municipal-interest tax exemption costs the Treasury every year. The obvious way to do that would be to restrict or ban tax-exempt financing for purely private purposes, such as building sports arenas. Closing that loophole would force muni investors to own only bonds that served a public purpose, such as general-obligation debt or bonds used to finance school construction. Limited supplies would logically drive up the value of existing bonds, a bonus if you already own high-quality, long-term munis or buy them before investors begin anticipating that the loophole will be closed. Meanwhile, you can buy tax-free munis that pay more than taxable Treasuries do; yields in early July averaged 3.2% for high-quality, ten-year munis, compared with 3.0% for ten-year Treasuries. Or consider a low-cost mutual fund, such as Vanguard Intermediate-Term Tax Exempt (symbol VWITX) or Fidelity Intermediate Muni Income (FLTMX), a member of the Kiplinger 25.