Yesterday, I showed you how extreme fear has created an amazing opportunity for income investors. Right now, tax-free muni bonds – essentially, loans to state and municipal governments – are paying more than the equivalent taxable bonds.

That’s extremely rare. And it means we have the opportunity to collect double-digit, tax-free income if we’re willing to ignore the hype.

Three months ago, Wall Street sensation Meredith Whitney – best known for her bearish call in the fall of 2007 on Citigroup – predicted 50-100 “significant” municipal bond defaults that would add up to “hundreds of billions of dollars.” A truly frightening prospect…

And since then, more than $30 billion has exited municipal bond funds. The pace is slowing a bit… But this is exactly the thing the herd does at exactly the wrong time. Everyone’s running for the exits just as things are turning up for municipalities.

[ad#Google Adsense]For example, in the third quarter of 2010, state tax revenues rose 4.5% from the prior year. Fourth-quarter revenues jumped 7% – a strong sign (although still below the peak levels of 2007).

But give it time. The economy is chugging along slowly. As it improves, states and localities will collect more revenue.

One idea circulating argues that overall municipal debt, around $3 trillion, is unimaginably large and far too great to ever pay off… or for the states and localities to even cover the interest payments.

This simply isn’t so…

First, many state and local governments have legal requirements to balance their budgets… and that means facing the reality of their fiscal decisions. Sure, property taxes are down and may go lower. But municipalities generally don’t shirk their moral obligations.

In many places, budgets will be cut before the governments default on their bonds. Local citizens will start taking on some of the ancillary responsibilities. That’s why Whitney is wrong. We’re already seeing this in places like San Diego, where private citizens have started caring for the parks and dealing with trash.

More important, the key question surrounding default is whether the municipality can cover its interest payment, or “debt service.” Turns out the debt service makes up a small part of the average state budget. The ratings agency Fitch reports debt service is “less than 10% of the government’s budget.” Income and property taxes are half that percentage at the state and local levels. Hardly reasons to renege on municipal debt.

Or look at it another way… Take the total muni debt of roughly $3 trillion and say the average cost of the interest is 3% a year. That means total interest cost is $90 billion a year. Compare this to the state tax collections of $715 billion in 2009. Worst case, if all the muni debt was to be “guaranteed by the state” as some people claim, we’re talking about less than 13% of the total revenue to pay the interest.

[ad#article-bottom]From a legal standpoint, it’s hard for localities to go bankrupt, which can mean walking away from local citizens who live off the income of the bonds. The worst case in modern history is Orange County, California. It went bankrupt over derivative trading losses… But eventually, the county paid every dime it owed on the bonds.

And there’s more evidence to lead us to think things are improving and “hundreds of billions in default” is hyperbole.

In my lifetime, 2008 was the record for muni defaults, but only a tiny $8.5 billion defaulted. And last year, 2010, it was only $2.8 billion. Remember, the muni bond market is gargantuan: more than $3 trillion in outstanding municipal bond debt. You would think we’d have seen a lot of defaults by now. But we haven’t. It seems things are getting better, not worse.

That’s why I think it’s a great time to buy muni bonds.

Good investing,

— Doc Eifrig

[Daily Trade Alert note: If you’re looking for a specific muni bond idea, consider the Nuveen Insured Municipal Opportunity Fund (NYSE: NIO). This fund pays a taxable equivalent yield of around 10% in monthly installments. Read more…]

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Source:  Daily Wealth