We should thank high-profile analysts for their predictions of doom and gloom in the municipal bond market. Their pessimism has created opportunities for the rest of us.

After a generally positive 2010, municipal bonds experienced a sharp sell-off in the fourth quarter as worries that many believed had been put to rest resurfaced.

A number of pundits expressed concern over the state of municipal finances in the back half of the year. In testimony before the Financial Crisis Inquiry Commission in June, Warren Buffett said that municipalities face significant financial challenges over the next five to 10 years. He noted that if the federal government will “step in to help them, they’re triple-A. If the federal government won’t step in to help them, who knows what they are?”

In November, Chris Whalen of Risk Analytics predicted that because the government would be unwilling to bailout states swimming in red ink, California was likely to default in the near-term. But perhaps most disturbing was Meredith Whitney’s statement in a December 60 Minutes interview that between 50 and 100 American cities would end up filing for bankruptcy in 2011. Defaults on this level could cost municipal bond investors hundreds of billions of dollars and trigger another downward leg in the financial crisis, she said.

But their worries, at least for now, have mostly failed to materialize. Municipal default rates in 2010 remained in line with low historical norms, with no major default events last year.

In fact, the financial picture for municipals improved last year and will likely continue to do so in 2011.

Tax receipts rebounded in the first quarter of 2010, jumping by 3.9 percent compared to the fourth quarter of 2009. That trend continued throughout the year and market watchers have forecast a 4 percent gain in 2011. While that gain won’t close the budget gap in many states, improved receipts does set them on the proper footing for a fiscal recovery, particularly when coupled with spending cuts and tax increases. However, few states will require tax hikes such as what we’ve recently seen in Illinois.

The real story of the fourth quarter sell-off in municipal bonds is largely technical.

The rising yields in municipals almost perfectly mimicked the sell-off we saw in Treasury bonds in the quarter as investors began moving capital more aggressively into equities. As stocks surged in the fourth quarter and yields remained paltry on most bonds, equities appeared increasingly attractive to investors reaching for both yield and capital appreciation. Throw in the extension of the Bush-era tax cuts and you have a perfect recipe for an exodus from bonds of all stripes.

And in the political horse trading done to get the tax cut extension deal done, the popular Build American Bond (BAB) program found its way to the cutting floor. So even as municipalities sold $133 billion of debt in the fourth quarter, the second busiest quarter for municipal issuance in history, the expiration of the BAB program means we’re likely to see a huge jump in issuance activity this year. As we all know, the greater the supply of anything, the lower its value.

Given that the credit outlook for municipals is improving and there are bargains to be found in the market, now’s a great opportunity to pick up some tax advantaged yield on the cheap.

How to Play It

Although the overall credit situation is improving, some risks do remain in the municipal bond market, the biggest of which is interest rate risk.

While domestic headline inflation remains subdued and unemployment is stubbornly high, the odds of a rate hike are fairly slim. Still, inflation is heating up internationally and commodity prices are rapidly rising. There’s a very real chance this will bleed over into the US economy. That makes intermediate term bonds most attractive.

Additionally, while the credit situation is generally improving, pitfalls remain. Revenue bonds tied to income streams generated by airports and other infrastructure assets tend to be lower risk rather than general obligation bonds which are more economically sensitive because they’re backed by general tax receipts.

Overall, diversified open-end mutual funds and exchange-traded funds are your best bet for gaining exposure to municipal bonds though closed-end funds should generally be avoided.

A quick survey of closed-end municipal funds reveals high amounts of leverage and questionable portfolios. In a quest to maintain yields, most closed-ends have increased leveraged, with ratios running between 40 percent and 60 percent. Many have also grossly compromised on credit quality. In some cases, closed-end funds have even taken to making return of capital distributions to maintain yields. As a result, the yields of most closed-end funds simply aren’t sustainable.

That’s not to say that open-ended mutual funds are entirely innocent of using leverage to boost returns and yields, but the practice is much less common.

Both Vanguard Intermediate-Term Tax-Exempt (VWITX, 800-997-2798) and Northern Intermediate Tax-Exempt (NOITX, 800-595-9111) have been profiled in these pages in the past. These funds are predominately made up from general obligation bonds and eschew the use of leverage in their portfolios.

Both maintain solid credit quality with an average rating of AA, though the Northern fund tends to keep a slightly larger stake in lower rated issues. The Vanguard offering is better diversified, holding almost 3,000 individual issues, compared to the 300 bonds held by the Northern fund. The pair also offer yields in the 3 percent range after the fourth quarter sell-off, making this an opportune time to add some low-risk yield to your taxable accounts.