Top-rated 10-year muni yields fell as low as 1.77 percent Dec. 30, the least since data compiled by Bloomberg began in January 2009. The market returned 10.7 percent through Dec. 30 while Treasuries earned 9.8 percent, according to Barclays Capital indexes that track prices and interest income. The Standard & Poor's 500 Index of stocks was unchanged in 2011 and the S&P GSCI Spot Index of commodities rose 2.1 percent.

Even when adjusted for the risk of price volatility, municipal bonds beat Treasuries, investment-grade corporate debt and junk bonds, according to data compiled by Bloomberg.

Continued Struggle

Some state and local borrowers will continue to struggle to balance their books this year as the recovery sputters, Larkin said. U.S. gross domestic product grew at a 1.8 percent annual pace in the third quarter, the government said Dec. 22, less than the 2 percent initially estimated.

California, New York, Missouri and Washington have midyear budget deficits, according to the National Conference of State Legislatures. Detroit may run out of cash by April and faces a possible state takeover as Mayor Dave Bing and City Council members disagree on how to close a $155 million deficit.

"We're not out of the woods yet," Larkin said. "Defaults could go higher because the economy isn't helping things."

Larkin's firm doesn't expect defaults to exceed $20 billion this year, with less than a fourth of that among state and local governments. The rest will be in riskier special-purpose debt such as revenue-backed industrial-development, housing, nursing- home and airport bonds.

Vulnerable Issues

Investors still face vulnerability in lower-rated bonds and from cities that haven't dealt with revenue declines, said Richard Ciccarone, managing director with McDonnell Investment Management in Oak Brook, Illinois. He said about 2 percent of the 700 cities he follows don't have enough cash to cover 30 days of expenses.

"There's a probability that marginal players will default," said Ciccarone. "I don't think they're going to decrease."