Generations of investors have turned to municipal bonds for reliable income with little to no credit risk, but that trend has been turned on its head. Once-stolid munis have been shunned of late, victims, too, of plunging real estate values. Municipalities across the country face cash crunches because property tax revenues have dropped off, leading many to reevaluate budgets and slash services. Even Kansas found itself scrambling to find the cash to mail tax refunds.

California is an excellent case in point; the state government, as well as many local bodies, is in trouble. During the last US recession earlier this decade, California experienced a 26 percent decline in income tax revenue. The current recession will be longer and deeper, and many observers expect tax revenue to fall by as much as a third. Already some municipalities have seen real estate revenues fall by as much as half.

That’s hardly a bullish case for municipal bonds.

California’s travails represent the most extreme demonstration of the headwinds facing municipal bonds. And several other factors contributed to the municipal bond selloff. Many hedge funds used municipal arbitrage strategies and were forced to sell their most liquid positions in the face of margin calls and redemption requests. In addition, skittish investors dumped their holdings when major bond insurers were facing bankruptcy.

But 2009 will be a much better year for munis.

For starters, investors are beginning to move away from Treasuries, regaining their risk appetite and searching for higher yields. In December many municipal funds returned better than 2 percent primarily due to improving asset prices.

Municipal bonds will also benefit from the next round of stimulus coming out of Washington. Legislation is likely to include provisions that should improve liquidity for munis–such as allowing banks to buy more tax-exempt bonds. Substantial sums of money will also be passed along to states and municipalities to encourage projects such as infrastructure repair and education investment, alleviating some pressure on local budgets.

The key to successfully harnessing municipal bonds will be quality. Issues from the hardest-hit states such as California, Nevada and Florida should be largely avoided. Investors should demand high credit quality, sticking to investment-grade bonds.

An excellent way to pick up the high yields still offered by many municipal bonds while minimizing risk is Northern Intermediate Tax-Exempt (NOITX).

Managed by Timothy McGregor for the past decade, the fund isn’t a high flier in bull markets but isn’t the biggest loser in bear markets. It just plods along, generating modest capital gains while throwing off income by focusing on quality.

It sticks to highly rated issues, with more than 86 percent of its portfolio made of investment-grade bonds. The remainder comprises unrated issuers that meet McGregor’s exacting cash flow standards. It has also largely avoided the highest-risk states, holding few issues coming out of California, Nevada and Florida. That’s kept the fund’s performance in the top quarter of intermediate muni funds over the past two years. Its peers have been hammered by bond insurer blowups, the subprime meltdown and hedge fund selling.

That the fund has avoided general obligation bonds issued by localities, is light on housing issues and holds no industrial bonds only adds to its security. The portfolio’s focus is on general obligation bonds, which can be funded through any tax revenues, essential services bonds tied to utilities, and transportation revenues and tax-exempt bonds backed by the US government. And it sticks to bonds issued by states with strong balance sheets.

A current yield of just less than 4.2 percent works out to a taxable equivalent yield exceeding 6.5 percent for investors in higher brackets. It’s almost impossible to find such attractive yields anywhere else in the bond markets right now. Municipal funds are out-yielding even many corporate bond funds on an absolute basis. That’s largely because there’s much more risk associated with owning municipal bonds now than there has been in years.

Property taxes are the primary source of revenue for municipal governments. And as anyone who owns a home or a car knows, how much you pay is determined by the value of the property. As property values fall, cities and counties have less cash coming in.

However, a rash of defaults is fairly unlikely because municipalities have the power of taxation. Also, with most types of municipal bonds if the locality defaults the state itself is on the hook.

If there are bankruptcies, they’ll most likely occur in places such as Jefferson County, Alabama. In order to lower the overall cost of its bond issuance, the county entered into interest-rate swaps with banks that helped underwrite offerings. As rates soared last year, Jefferson County found itself potentially on the hook for a lot of money.

But municipalities engaged in derivatives contracts to help finance debt issuance are rare, so there’s probably little risk going forward. But that perceived risk can generate sizable returns for investors in the meantime.

Northern Intermediate Tax-Exempt
Chicago, IL 800-595-9111      NOITX
www.northernfunds.com Sales fee: none
Assets: $1.1 billion
Early withdraw: none
No. of holdings: 228
Turnover rate: 266%
Expense ratio: 0.75%
Yield: 4.2%
Assets in top 10 holdings: 13.8%
Min. initial investment:  $2,500; $500 if IRA
Largest quarterly loss*: -2.6%; 3rd Qtr 2008
Largest quarterly gain*:  2.9%; 4th Qtr 2008

*Past three years

Source: Morningstar