Is the municipal bond glass half empty or half full? Lately, it looks half empty.

Financial advisors are keenly aware that the muni-bond market today is in sad shape. How sad is open to dispute. The Center on Budget and Policy Priorities, a Washington, D.C., nonpartisan research institute, was projecting state budget deficits of $200 billion for 2010.

However, it estimates those state budgets deficits should shrink to $180 billion and $120 billion in 2011 and 2012, respectively. As of October 2010, that year's $1.6 billion in defaults in municipal securities represented a decline from $8 billion in 2008 and $7 billion in 2009, according to the Distressed Debt Securities Newsletter, Seattle. But that newsletter expects defaults to rise in 2011 because Uncle Sam's economic assistance may decline, and state budget problems could hinder debt payments.

Meanwhile, states also face unfunded pension liabilities of $1 trillion, according to the Washington, D.C.-based Pew Research Center. The state of Illinois staved off a potential default by issuing $1.5 billion in tobacco bonds in December 2010. The proceeds were expected to let that state pay its bills. Meanwhile, cash-strapped California issued $3.3 billion in bonds to beef up that state's coffers.

With all the bad news, it's becoming tough for financial advisors seeking a safe haven for conservative clients to turn to individually insured municipal bonds or bond funds. Adding to their difficulty is the disappearance of bond insurers after the 2008 financial collapse. The Hamilton, Bermuda-based Assured Guarantee Ltd. is the only company insuring bonds, according to The Wall Street Journal. And there no longer are any municipal bond funds that carry an average top AAA credit rating because of all the credit downgrades, according to a report by the Aite Group, a Boston-based research and advisory firm.

There also are concerns that since Standard & Poor's, Moody's and Fitch recalibrated their muni-bond ratings to be more comparable with corporate bond ratings, many municipal issues have been upgraded.

Municipal revenue growth could be hindered for several years, according to a November 2010 survey by RBC Capital Markets in New York, the investment bank affiliate of Royal Bank of Canada. More than half of industry professionals surveyed say it could take at least five years before state and local government revenues return to pre-crisis levels. Driving concerns is the anticipated decline in the level of federal assistance for state and local governments over the next three years.

"While state and local governments have seen steep declines in revenues, the risk of defaults on bonds issued by these municipalities generally remains well below similarly rated corporate debt," says Chris Mauro, director of municipal bond research at RBC Capital. "Despite the fact that municipal credit quality has deteriorated in this recession, the public perception that municipal bonds have become a riskier asset class relative to corporate debt is simply not true."

It could take a long time, however, before economic conditions improve. State tax revenues are down 12% since 2008. In 2010, 46 states struggled to balance fiscal year budgets, reports the Center on Budget and Policy Priorities.

Adding fuel to the fire were concerns about the accuracy of the bond rating agencies' municipal bond ratings. At a hearing in New York last month, state insurance regulators were concerned about how much the bond ratings reflect current financial data, government pensions and health-care liabilities. Many states are notoriously slow to complete annual financial audits.

Daniel G. Loughran, senior portfolio manager of the OppenheimerFunds Rochester Investment Team, says that the bond rating agencies "have done a good job over the years rating municipal bonds compared to structured products." He does his own credit analysis. Nevertheless, he feels comfortable enough with the recalibration of ratings to make them comparable to corporate bonds.

Unfunded pension and health-care liabilities are another major investor concern. Liabilities could be more than $1 trillion if post-employment benefits-like health care-are factored.

"We're talking about a significant amount of underfunding and it is definitely a long-term problem for the market," says Hugh McGuirk, head of T. Rowe Price's municipal bond team. "But you have to remember that states are required to balance their budgets annually. Many of these pensions are contractually obligated to meet pension payments. They have to factor that on an annual basis. So many state legislatures have been making a lot of tough decisions. A significant amount of cuts have been made already, but there's still more work to do."

The oversupply of bonds and concerns about bond ratings and pension obligations came to the forefront in November 2010. A market sell-off saw some municipal bond prices drop as much as 4% to 7%. And investors pulled $5 billion out of municipal bond funds the week ended November 17, according to the Investment Company Institute in Washington. The redemptions reflected fears of higher interest rates hitting muni bond prices as well as the changing outlook for high taxes next year with Republicans in control of the U.S. House of Representatives. But since then, money returned to municipals as investors sought high yields.

McGuirk says the decline was due to supply-demand factors, not fear of defaults. Entities are rushing to market with Build America Bonds before the government-sponsored program could terminate at the end of 2010. And in June 2011, more federal aid to states and municipalities might stop under the government's job and stimulus bills.

Currently, investment-grade municipal bonds yield more than 100% of nominal 30-year Treasury bonds. But McGuirk expects bond prices soon will stabilize.

Early this year, T. Rowe Price's Summit Municipal Intermediate Term Fund shortened its duration to about 4.5 years compared with its benchmark's 5.4 years. That reduces the fund's interest rate risk. The fund, however, picked up some yield by taking a position in California general obligation bonds which yield around 8%. Forty-one percent of the fund's portfolio is invested in revenue bonds, which are tied to stable income streams. About 25% is in general obligation and health-care issues.

"The sell-off in the municipal bond market was not driven by defaults or credit-related events, but rather a temporary supply-demand imbalance," McGuirk says. "Municipal issuance has increased in recent weeks as issuers are attempting to take advantage of near-record low rates."

In the meantime, the municipal bond market is under heavy pressure due to issuance oversupply. Demand for municipal securities has weakened in part because absolute yields have reached low levels.

Loughran, of Oppenheimer, says the recalibrated municipal ratings have created buying opportunities. His own analysis has identified a number of underrated issues, particularly in nonprofit college revenue bonds and tobacco bonds. These are cash cow positions that pay attractive yields. He also added some lower credit-rated and non-rated bonds to the Oppenheimer AMT-Free Municipal Bond Fund. The fund's three largest sectors, which represent 45% of the portfolio, are in tobacco master settlement agreement bonds, special assessment bonds and hospital-health care issues.

Loughran, like other municipal bond portfolio managers, favors state tax-backed bonds and essential services bonds, particularly in the Southwest and Southeastern states where budget problems are less serious. "These problems in the municipal bond market are for taxpayers, not bond investors," he says. "We take a bottoms-up approach to investing. We favor long maturity bonds in the new and secondary markets that represent the best values in terms of yield and credit rating. Over the long term, these bonds offer the highest yield and total returns for income investors."

Loughran says there will continue to be a lot of volatility. States are attempting to cut budgets, increase taxes and gradually reduce unfunded pension liabilities. They are taking steps to improve their financial conditions and avoid defaults.

"It takes a crisis before they cut expenses and raise taxes," he says. "It's not a popular thing to do. Improvements in public finances tend to lag what happens in the economy. But this is the third quarter in a row where state tax revenue has increased. Last month [October 2010], tax revenue increased 6%."

Loughran stresses that financial advisors should focus on how much clients are willing to see their municipal bond values drop over the short term. Concerned investors should stick with higher-grade shorter-term bonds because they are less volatile.

Philip Condon, head of the municipal bond portfolio of DWS Investments, says that despite the volatility, municipal bonds should still be considered a core allocation for fixed-income portfolios. "Despite some changes in the market's volatility and valuations, which can seem very ominous while they are taking place, the fundamentals have not changed," he says. "We have to remind ourselves to maintain perspective."

Condon favors revenue bonds over general obligation issues. The DWS Intermediate Tax/AMT Free Fund, has 60% of its holdings in investment-grade-rated revenue bonds. General obligation issues make up 24% of the portfolio. Pre-refunded bonds, which are bonds backed by U.S. Treasurys, make up 5% of the portfolio. He has 20% of assets invested in Texas. Plus, he has 14% of holdings in California general obligations, which he says are performing better.

"The fund's position in California general obligation bonds, backed by the full faith and credit and tax power of the state, performed well [in the third quarter]," he says. "The fund has been adding exposure to 'A'-rated airport issues and health-care-related bonds in the 'AA' to 'A' range."

Financial advisors are concerned. Barry Mendelson, a Walnut Creek, Calif.-based financial planner, would rather stick with Vanguard's municipal bond funds and two iShares exchange-traded funds, the iShares S&P National AMT-Free Municipal Bond fund (MUB) and the iShares S&P Short-term National AMT-Free Municipal Bond Fund (SUB).

"The fundamentals and creditworthiness of municipal and tax-exempt bonds is all over the map," he says. "That is why expert credit analysis is required when buying individual issues. Therefore, due diligence and credit analysis has never been more important."