"The fundamentals of municipal credit are being challenged in the most basic ways affecting revenue, property and income taxes," says Heaney. With the municipal market a lagging indicator of economic trends, he fears that risks could increase if the U.S. economy falters and the federal government doesn't provide additional relief.

In this scenario, bond prices could retreat again. But a rise in default risk would likely be seen in the less understood corners of the market, which is somewhat akin to the mortgage-related debt market where investors really didn't understand the securities and their underlying risks.

Savader believes that we could see a tenfold increase in the historically modest rate of default, which is normally 10 to 20 issues a year, because of the greater complexity of familiar-sounding state and local issues that are actually backed by third parties with untested revenue streams.

These include specialized revenue bonds backed by troubled real estate development, not-for-profit hospitals, and universities that are financially overextended with limited recourse. "Investors may not be completely clear that when a private entity issues debt through a municipal name, it is this issuer, not the umbrella authority or government, who is solely responsible for this debt," says Savader. And managers may find that this exposure is canceling out much of the risk control they thought they were securing by simply diversifying investments across different states.

Opportunity
While risk has increased, so has the opportunity to lock in remarkable yields and capital gains on depressed bonds.

David Fare, co-portfolio manager of Legg Mason Partners Managed Municipal Fund, turned over half of his $4.8 billion portfolio in the past year because he felt market dislocation offered a rare opportunity. "When everyone was ducking and running for cover in ultrasafe securities," Fare explains, "we were able to sell pre-refunded bonds [debt that has been refinanced at rates below the original coupon with proceeds set in escrow until the bonds can be called] at a high price and convert proceeds into cheaper and higher-yielding munis that investors were avoiding, such as revenue-backed water, sewer, transportation, housing, hospital, power and education bonds." Like many fund managers, he's been overweight revenue bonds because their risk-return profiles have been more desirable than general obligation tax-backed bonds.

MFS' High-Income Fund manager Geoffrey Schechter has done the same. Over the past year, he has added to his holdings of a New York City Industrial Development Authority Bond that raised funds for American Airlines operations at Kennedy International Airport, collateralized by the airline's gates at JFK. This "B-" rated bond, due in 2025, is not for the faint of heart. It's eye-popping triple tax-free coupon of 7 5/8 percent (though partially exposed to the alternative minimum tax), is 300 basis points more than AAA-rated municipals. After dropping below 80 in August, it had rallied back to 98 as of mid-October.

To Schechter, the bond's underlying security is in the inelastic demand for gates at the country's largest international airport hub. But Konstantine Mallas is wary of such high-risk asset-backed securities, saying that collateral claims, especially in bankruptcy, are rarely clear cut.

With an exclusive focus on investment-grade municipals, Mallas recently picked up an "A-" rated, 30-Year New York State Dormitory Authority bond at 96 7/8, yielding 5.37%. That's about 110 basis points higher than a triple-A-rated municipal. The bond is backed by the Mount Sinai School of Medicine, and Mallas believes that in addition to the school's stable finances, the prestige of this teaching hospital and its endowments suggest a significant degree of safety.

MainStay's Robert DiMella has found special opportunity on the edge of investment-grade issues that the market may not fully understand.  He points to his two percent exposure to the Newark, New Jersey Housing Authority Bonds due in 2038 that came to market with a tax-free coupon of 6.75 percent.