Two months ago, panic-stricken municipal bond investors were fleeing for the exits. The muni market was roi fears that issuers would default and bond insurers couldn’t make good on their guarantees. Bond prices plunged. Yields, which move inversely to prices, were the highest relative to comparable Treasuries in half a century.

Now the fears appear to have been largely overblown, and what seemed like a crisis was really an opportunity. The pendulum is swinging in the other direction as value-seeking investors move back into the market — but bargains still abound.

For example, Western Asset Municipal High Income Fund (NYSE: MHF) had hovered around $8 a share for the past decade. Then last September it began a steep plunge, hitting a low of $5.12 a share on October 10th. Back then, it was yielding an unprecedented 8.7%. Today, the yield has come down, but it’s still a very rich 6.3% ($0.444/$7.04).

#-ad_banner-# That may not sound like much, but the income is tax-free. You would have to get an 9.7% yield on an ordinary taxable bond fund, if you’re in the top 35% federal income tax bracket, to match what you would earn from that yield. And as muni markets continue to rally, the price could rebound toward the $8 level, bringing even greater returns.

$33,000 more income from tax-free munis
Muni prices are rallying in part on Obama’s plan to raise the top tax rate from 35% to 39.6%. But you don’t have to be in the upper tax bracket to rake in higher returns from these tax-free bonds.

Most bond income is taxed at your ordinary income tax rate. Suppose you’re getting interest income of $5.00 annually from a corporate bond fund. You might actually pocket just $3.25, if you’re taxed at the 35% federal rate, and you’ll get even less if there’s state or local taxes.

In contrast, municipal bonds are tax-free. When you buy a municipal bond, you are lending money to a state or local government to build bridges, roads, or other public projects. The bonds are exempt from federal income taxes because the federal government can’t tax state securities, just as states can’t tax federal securities. And if you live in the state or municipality of that loan, the local government usually foregoes the taxes, giving you a double or triple tax-free investment.

The tax-exemption makes muni yields far more attractive than you might think at first glance.

Consider two investment choices.

— “Multifamily Housing Revenue due 08/01/2039” is a tax-free municipal bond issued by California Housing Finance Agency that carries an “AA” rating from Standard & Poor’s and now yields around 7.0%.

— GE Capital’s “Global MTN Series A due 01/10/2039” is a corporate bond with an “AAA” rating from Standard & Poor’s and selling today with a yield of about 7.8%.

Which one would you spring for? Both bonds carry quality credit ratings and mature in 30 years, but the GE Capital bond offers a higher yield. Or does it?

Using a tax-equivalent yield converter freely will see that the GE Capital bond would need to yield around 10.8% to match the yield on the tax-free California muni (assuming an income tax rate of 35%). The taxable equivalent yield is even higher if you live in the state of CalIPOrnia.

The yield difference really adds up. Although the GE Capital bond yields 7.8%, once Uncle Sam takes his share, the after-tax yield is just 5.1% (assuming the 35% tax rate). The after-tax income generated from a $100,000 investment would fall from $7,800 to $5,070. That compares with $7,000 tax-free income from the California muni.

The difference may not seem like very much, but compounded over ten years, your muni would earn $96,717 versus just $63,979 for your corporate bond — a difference of almost $33,000!

Of course, the tax advantage munis provide aren’t as appealing if you can shelter your income in an IRA or other tax-deferred account. However, if you’re at the maximum allowable contribution limit and are looking to protect your assets from the taxman, munis and the funds that hold them are well worth considering.

Aside from their tax-free income, munis enjoy many other advantages, but you need to read the fine print.

Munis are safe but…
Municipal bonds have long been considered one of the safest investments around, and that reputation is well-deserved. The average cumulative 10-year default rates for investment grade munis over the 35 years from 1970 to 2005 is just 0.07% versus 2.23% for equivalent corporate bonds, according to Moody’s Investors Service (NYSE: MCO).

Still, last year the muni market suffered one of the most dramatic declines in a quarter of a century. The market was roiled by the insolvency of municipal bond insurers and the pristine Triple-A credit rating they had assigned to about half of all munis was thrown into doubt. Nor did it help that over-leveraged hedge funds seeking to raise cash flooded the market with munis or that frozen auction markets brought demand to a halt.

National long-term muni bond funds lost an average of -9.4% last year, according to fund tracker Morningstar (Nasdaq: MORN). But the category has gained +6.1% so far this year, as investor fears subside. Still, risk-averse investors should tread carefully. While the risk of default is low, the deepening recession could affect returns, and some munis are safer than others.

Munis for the risk-averse
If safety is your top priority, general obligation bonds are your ticket. These bonds are backed by the tax revenues of the state, city, or school district that issues them. If needed, the issuer can raise taxes to repay the principal and interest.

For example, Morgan Stanley’s Insured Municipal Securities (NYSE: IMS)devotes some 12% of the portfolio to general obligation bonds like California State 4.25% due 08/01/2033 or Honolulu Hawaii City & County 9.6558% due 03/01/2026. In contrast, revenue bonds and industrial development bonds are backed by the revenue streams of a specific project or facility, which tend to be less secure.

#-editor_pick-# Pre-refunded municipal bonds can also offer a greater degree of security. These are previously issued munis which are secured by an escrow fund. Escrow funds using U.S. Treasuries or State and Local Government Series (SLGS) to make bond payments are generally the most secure. Nearly one-quarter of Western Asset’s Municipal High Income Fund, also profiled below, focuses on pre-refunded munis escrowed with U.S. Treasuries or agency securities.

Debt is a four-letter word
Most closed-end muni funds use leverage to juice yields. They borrow money by issuing floating rate preferred shares or investing in tender-option bonds and use these short-term loans to buy longer term, higher yielding munis.

The problem with preferred shares is government regulations prohibit leverage from rising above 200% of the fund’s assets. That means that when the value of the fund’s portfolio declines due to a market downturn, the fund can be forced to cut or suspend its distribution to preserve cash. More than two dozen leveraged closed-end funds suspended distributions and many more cut them last year in part due to asset coverage requirements.

Tender-option bonds don’t count as leverage for the asset coverage test, but the variable rate feature of these complex instruments introduces a layer of risk. With all this in mind, we’ve carefully chosen funds with minimal leverage. Neither of today’s featured funds have preferred shares outstanding. One of them, Morgan Stanley Insured Municipal Securities, does have a bit of leverage in the form of a tender-option bond that represents just 1.2% of its assets.

The sooner you get your money back, the better
Duration is another feature we kept in mind when selecting our top picks. Simply put, a bond’s duration refers to the number of years it takes for you to get back your original capital through both interest payments and the return of principal at maturity. A short duration of say two years means you will get back your capital in about two years, either from high interest payments or a short maturity date.

Duration also measures a bond’s interest rate risk. A bond or bond portfolio with a 10 year duration has a greater chance of suffering from rising interest rates. If rates rise, the bond price will fall to match the prevailing yield of new bond issues. Longer duration bonds generally offer higher yields to compensate investors for the greater potential risk. In seeking to balance the risk/reward profile of our top picks, we steered a middle course. MHF’s bond portfolio carries a relatively low-risk duration of just 4.2 years. IMS has an intermediate-term duration of 7.9 years but is positioned to benefit from the higher yields offered by longer term bonds in what’s expected to be a continued low interest rate environment.

The list of caveats could go on endlessly, but before we feature our top picks, we should alert you to two more signposts — credit quality and AMT taxes.

Ratings and taxes
Rating agencies have lost a lot of their credibility lately, but the fact is average cumulative 10-year default rates on sub-investment grade munis, rated BB+ or lower by Standard & Poor’s, were 4.29% for the 35 years through 2005 (versus less than 1% for investment grade munis). Also, the rating agencies still hold enough clout that a downgrade can pressure prices and hurt returns. For these reasons, we stuck with higher quality portfolios — MHF’s bond portfolio carries an average “A-” rating while IMS’ fully insured bond portfolio enjoys the highest “AAA” rating.

Finally, while most muni income is exempt from federal income taxes, a portion of the payout may be subject to the Alternative Minimum Tax (AMT). This tax adds back certain tax-exempt items into taxable income. Funds which invest in higher yielding munis issued by non-government agencies such as airports or housing agencies typically trigger the AMT for investors in the higher tax bracket. MHF’s holdings aren’t subject to the tax, but around 14% of the income earned by IMS’s portfolio holdings is subject to AMT.