(A foreclosed home is seen in Stockton, California in this May 13, 2008 file photo. In some areas of California, so many foreclosed homes are available to buy on the cheap that real estate agents are discouraging prospective sellers from even putting their houses on the market. Perhaps the most extreme example of this is Stockton, about 136 km (85 miles) east of San Francisco, where roughly three of every four homes for sale are in or on the path to foreclosure.)

Last week the Stockton, California, city council approved a plan to default on about $2 million of debt payments in an effort to avoid becoming the largest U.S. city to file for bankruptcy.

Stockton, a city of 292,000 people about a two-hour drive from San Francisco, is just the fourth major American city or county to spook the $3.7 trillion muni bond market over the last year. Harrisburg, Pennsylvania; Jefferson County, Alabama; and Central Falls, Rhode Island, have had to default or declare bankruptcy over the last 12 months. Detroit, meanwhile, is trying to close a $45 million budget shortfall by June.

Stockton's default comes some 15 months after Meredith Whitney, an analyst whose 2007 call that Citigroup Inc would have to raise capital or cut its dividend made her famous, incorrectly forecast "hundreds of billions of dollars" in municipal defaults in 2011. Whitney's call prompted a wave of selling in the municipal bond market. For investors who stayed the course, the broad muni market returned nearly 11 percent.

Stockton could be another opportunity to benefit from misplaced fears. Analysts say that municipal bonds still provide compelling investment opportunities, especially for wealthier investors who receive the most benefit from tax-exempt bonds.

Here are suggestions on how to play the municipal bond market now:

KNOW WHERE TO HOLD THEM

Unlike in Stockton, tax revenue in many cities is climbing. That could make certain local government municipal bonds less risky, analysts say.

State tax revenues were up 6.1 percent in the third quarter of 2011, the seventh straight quarter of growth. Tax collections nationwide are just 3.5 percent below pre-recession peaks.

A short supply of new issues could push the market higher, analysts say. Peter Hayes, head of BlackRock Inc's municipal bonds group, said that local healthcare, education and transportation revenue bonds should continue doing well in 2012. He also has a positive outlook for state general obligation bonds.

"(State) balance sheets are better now than in the past few years. Their revenues are up and spending is going down, leaving the credit fundamentals in the broader market very, very strong," he said.

Hayes said that investors should not consider Stockton the first domino to fall in a larger picture. "The market is always subject to a lot of headline risk because the retail investor plays such an important role ... but this year you will only see a few Stocktons," he said.

However, worried investors should be wary of holding municipal bonds issued by exurbs, he said. Bedroom communities about 80 miles or more from very large cities were the most likely to see their housing markets overbuilt in the 2000s, and will likely watch their economies struggle for years, he said.

Investors should note, too, that the declaration of default does not always mean that their principal is worthless. According to James Spiotto, a muni bankruptcy expert at the law firm of Chapman and Cutler, 49 of 264 municipal bankruptcies filed since 1980 involved cities, counties and villages, and 31 percent of the filings were dismissed.

Benjamin Thompson, head of Samson Capital Advisors, suggests looking toward revenue bonds in essential infrastructure subsectors like water and local utilities. For the more cautious investors, consider revenue bonds in the Washington, D.C., area and Texas, where the local economies are relatively strong. Investors looking for larger yields, meanwhile, should consider revenue bonds in states like Illinois and New Jersey where concerns about pension obligations and tax revenues have led to lower-than-average state credit ratings.

"These securities can give you incremental yield but with a strong credit backing because they have a definable stream of payments to retain that debt," he said.

WEALTHY? GO FOR INDIVIDUAL BONDS

For very wealthy investors, the municipal bond market could flip the idea of diversification on its head. David Katz, senior portfolio strategist at WeiserMazars Wealth Advisors, said that individual bonds give wealthier investors a better way to manage their income streams.

He recommends a mix of general obligation and revenue bonds for his clients, but keeps them out of bonds backed by waste, hospitals or airport revenues. "These issues are more esoteric and tend to be more volatile," he said.

The broader investor base can still benefit from municipal bond funds, especially those who live in states like Florida and California that offer tax-exempt long-term bonds.

Vanguard's $2.8 billion California Long-term Tax-exempt fund (VCITX), for instance, offers a tax-free yield of 4 percent for California residents. The fund, which costs 20 cents per $100 invested, has returned an annualized 8.1 percent over the last three years. Its largest holdings are in bonds issued by the state Public Works Board and University of California.

"Thanks to the fund's razor-thin expense ratio, (it) doesn't need to venture into risky credits in order to compete," said Shannon Kirwin, an analyst at Morningstar, in a recent report.

ETF investors could opt for the $1.1 billion SPDR Nuveen Barclays Capital Muni Bond fund (TFI), though its returns will be exempt only from federal taxes.

The fund, which costs 23 cents per $100 invested, yields 2 percent. For someone in the top 35 percent tax bracket, that equates to a 3.09 percent tax-equivalent yield.

SOURCE REUTERS