After performing reasonably well for most of the year, the fourth quarter brought a steep decline in the performance of municipal (muni) bonds.

There are several reasons for the downturn in munis. Many investors grew concerned that the Federal Reserve’s second round of quantitative easing might open the floodgates to rampant inflation. Noted pundits such as Warren Buffet, Chris Whalen of Risk Analytics and Meredith Whitney began to sound the alarm about the creditworthiness of municipal debt as it became clear that there was more belt-tightening to come.

Although inflation risk is a legitimate long-term worry–one which we’ve addressed on several occasions–concerns over creditworthiness are largely overblown precisely because of budget cuts.

Unlike the federal government, municipalities can’t turn on the printing press during hard times. Municipalities are far more likely to cut discretionary spending when necessary.

Finally, it’s important to consider that most of the people raising alarms about the safety of municipal bonds are known for the prowess in the equity markets, not bonds.

The selloff in munis wasn’t driven by any legitimate concerns over quality; rather, it was largely due to simple supply and demand. The fourth quarter saw heavy issuance of new municipal bonds as issuers moved to balance books and take advantage of favorable rates. Additionally, it became clear that the Build America Bond program would be allowed to expire on December 31, 2010, which will lead to an increase in issuance of tax-exempt bonds in 2011. Finally, the extension of the George W. Bush-era tax cuts helped dampen demand for tax-advantaged bonds.

This should be a more favorable year for municipal bonds. Slow growth won’t kindle major inflationary pressures but it will help improve state and municipal revenues. Furthermore, the fourth quarter selloff has made the yields offered by municipal bond funds all the more attractive.

Marshall Intermediate Tax-Free (MITFX) is one of the best municipal bond funds available to investors.

Co-managed by John Boritzke, who’s been at the helm of the fund since its 1994 inception, and Duane McAllister, the pair takes a low-risk approach to running their portfolio. That conservative bent has paid off. The fund remained in the black in 2008, returning 0.7 percent while the majority of its peers lost money as the credit crisis intensified.

Avoiding riskier issues such as airlines and tobacco bonds, Boritzke and McAllister maintained a high quality portfolio–they bumped up average credit quality to AA in 2007 and 2008. This approach helped the fund avoid most of the turmoil.

Management prefers revenue bonds over general obligation bonds. Though the credit risk associated with general obligation bonds is often overblown, they are tied to the overall tax revenues of the issuer. This makes them more sensitive to swings in the economy than revenue bonds.

While revenues generated by facilities such as airports and utilities can decline in response to a sagging economy, the presence of a recurring income stream does make revenue bonds more secure. Currently the majority of the fund’s assets are in revenue bonds.

The managers also take pains to limit volatility. They aren’t afraid to hold a large cash stake, generally between 5 to 10 percent of assets. This cash allocation helps moderate volatility in tumultuous markets and leaves the duo with plenty of dry powder for when the turmoil has passed. The fund has also nearly doubled the portfolio to 578 holdings in order to dampen the effect of issuer-specific credit worries. The fund also eschews derivatives, financial instruments that can lead to big swings in performance.

Such a conservative bent has its downside. The fund tends to underperform in bull markets when quality is less of a concern; this makes the fund suitable for long-term investors. The payoff is worth the wait. Marshall Intermediate Tax Free has outperformed about 90 percent of its peers over a 10-year cycle and ranks in the top 1 percent of its category on a three- and five-year basis. An expense ratio of 0.55 costs and a tax-advantaged yield of 3.6 percent ensures that you’ll well paid in the meantime.