In short, state governments are broke right now... and it's about to get worse.
Unlike the federal government, state and local governments can't print money to fix their problems. The municipal bond market is where state and local government go to borrow money from investors. California, for example, is the largest issuer of municipal bonds in the country. So when California runs out of money, it's either going to default on its loans in the municipal bond market or the federal government will have to bail it out with a huge loan.
The market has pushed up yields on municipal bonds to account for this risk. Many fund managers and professional investors say municipal bonds are a great deal right now because you can get after-tax yields approaching 10% for the next 30 years by buying AAA-rated municipal bonds.
 
There's one type of municipal bond safer than any other. It's called a "prerefunded municipal bond." These bonds are a great deal right now...

 Example… a state government needs $100 million to build a hospital. It issues bonds to raise the money. Interest rates are high. So the state must pay 8% interest.
 
But then interest rates fall to 4%, and the state decides to refinance. It issues a new bond with 4% interest and uses the money it raises to pay off its debt on the first bond. Except you can't just pay off a bond anytime you like. You have to wait until the bond becomes "callable," or eligible to be paid back. So the state government invests the proceeds in Treasury bonds – the safest place in the market – until it can pay off the first bond.
 
The first bond is now a "prerefunded bond" because the state has already paid back the principal. It sounds complicated, but here's the point: There's no possible chance of default.
Because you're buying a risk-free Treasury bond in disguise, the yields on prerefunded muni bonds are lower than yields on regular muni bonds. But the income is still tax-free and yields are much higher than Treasury bond yields.
 
For example,  a 20-year California prerefunded bond trading at 5.85%. In a high-tax state like California, that's a true after-tax yield of almost 10%.
 
If you'd like to buy a prerefunded muni bond, call up a broker and ask to speak to the bond expert. Every major brokerage house has one...

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