On one level, munis are certainly cheap, even after the spirited rally they've put on since mid-December.

Normally, bonds issued by state and local governments yield less than Treasuries of the same maturity. Reason: Muni interest is exempt from federal income tax.

Yet the Bond Buyer Index of long-term municipals recently yielded 5.6%, versus 3.8% for the longest-dated Treasury bond. If yield were the only consideration, munis would rate a screaming buy.

A Complex Question

But it's not that simple. For one thing, the global financial crisis has driven Treasury yields into the basement. Investors around the world, in a "flight to safety," have piled into Uncle Sam's paper, even though our government is issuing enormous amounts of debt.

Once the panic passes, Treasury yields will spike — especially as folks recognize the inflationary impact of all the money the Federal Reserve is creating to sop up the government's bonds.

In short, there's an unreal aspect to Treasury yields right now. It makes more sense to compare other investments (such as munis) with their own history, rather than with Treasuries. By that yardstick, muni yields aren't so far out of whack — only about half a point above their average of the past five years.

Then there's the elephant in the room: The risk of default.

Since 1970, only about 0.1% of munis have failed to pay principal and interest on schedule. However, defaults have picked up sharply in the past 12 months. In 2008, a record $7.5 billion worth of bonds defaulted.

If the economy remains in the dumps or worsens, many more munis will run into financial difficulty. And bond insurance may not bail out investors, because most of the insurers who purport to back municipal bonds are themselves on the ropes.

I'm not particularly worried about most state governments. But I'm watching the California budget charade with some unease. Over the long run, the Golden State can't hope to balloon its debt 22% a year (as the new budget contemplates).

Other states whose finances look bleak at the moment include Michigan, Nevada, Illinois, Ohio, Florida and New Jersey. Ditto for Puerto Rico. If you're a resident of any of these latter jurisdictions, you should keep an eye on budget developments at the capitol. A swing toward dramatically higher state borrowing could signal rising default risk down the road.

Of greater immediate concern are the…