San Bernardino is going bankrupt. Stockton is defaulting on its debt. And other cities are grappling with similar financial strains.
That wouldn't seem to be a good environment for municipal bond mutual funds, but they keep rallying anyway.
The average long-term California muni fund notched a total return of 2.5% in the second quarter, according to fund trackerMorningstar Inc.Muni bonds in the state are up 6% so far this year and 13.4% over the last 12 months. Total return includes interest payments and appreciation in the value of the underlying bonds.
California muni bonds have been propelled by several factors, including limited supply and a dearth of decent-yielding investment alternatives.
The market also has been buoyed by fear of rising taxes, as investors worry about how lawmakers in Washington will deal with the federal government's fiscal problems. That has stoked interest in munis, which generally are exempt from state and federal income taxes.
And like other areas of fixed income, munis have been helped by falling market interest rates, which have boosted the value of older, higher-yielding securities.
Underlying it all, analysts say, is that the muni market has defied predictions of imminent collapse. Investors have braced for a wave of losses ever since prominent Wall Street analyst Meredith Whitney predicted in late 2010 that defaults would total hundreds of billions of dollars within a year.
But defaults nationwide have remained low. Many experts say the dire prediction was vastly overblown at the time and that nothing of the sort will happen now.
"As we continue to see that the sky is not falling, muni performance has been good and steady," said Patrick Early, chief municipal analyst at Wells Fargo Advisors.
Fewer than 0.1% of all muni issuers have reneged on their obligations so far this year, according to research firm Municipal Markets Advisors.
There were 42 defaults in this year's first half, down from 68 in the first half of 2011 and 83 in the first six months of 2010, according to MMA. The $810 million in defaults this year amounts to 0.02% of the $3.7 trillion in outstanding muni debt.
"In absolute numbers, these are still very, very low," said Matt Fabian, managing director at MMA. "There's no evidence of the credit fears having played out as people worried about."
Though many analysts agree with Fabian, not everyone is so sanguine.
A growing number of issuers have fallen into financial trouble this year, foreshadowing coming problems, said Richard Lehmann, president of Income Securities Advisors Inc. in Miami Lakes, Fla.
"Was Meredith Whitney right? Yes and no," Lehmann said. "She was right, but she was off timing-wise, and the order of magnitude was off. There's going to be a significant increase in default rates but it's not going to be hundreds of billions of dollars."
That hasn't scared away investors, who have flooded into muni funds.
Investors have poured a net $28.2 billion into muni funds so far this year after yanking $12 billion last year, according to Morningstar.
Part of the bonds' appeal is that other types of investments have become so unappealing as interest rates have plummeted, pulled down by the Federal Reserve and the weak global economy.
"You don't hear people saying, 'Oh, boy, munis are enticing,'" said Marilyn Cohen, president of Envision Capital Management, a West Los Angeles firm specializing in bonds for small investors.
"They're just sucking it up and saying, 'It's better than nothing — better than my money market, better than my CDs and better than paying more tax,'" Cohen said. "It's the lesser of all the evils."
That's particularly true in California, whose financial woes have forced it to pay higher interest rates than other states for years. Credit rating firms classify California as either the lowest- or second-lowest-rated state, though the added risk increases bond payouts for investors.
The muni market also has been helped by reduced bond issuance. As municipalities have cut back on capital projects and reduced their borrowing in the weak economy, investors have been left to nibble at a smaller pie.
Excluding refinancings of older bonds, municipalities are expected to issue $165 billion in new bonds this year, the lowest level in a dozen years and down from $280 billion in 2010, according to MMA and the trade publication Bond Buyer.
"Right now demand for bonds is outstripping supply," said Joe Gotelli, a California muni-bond manager at American Century.
What could throw the muni sector off course?
Aside from a broad rise in market interest rates, more fiscal problems in California.
MMA has put 11 California cities and redevelopment agencies on its list of troubled issuers in the last 18 months. The list includes the cities of Stockton, Mammoth Lakes and Fairfield and redevelopment and improvement districts in Arvin, Grover Beach, Hercules, Lancaster, Riverbank, Tehachapi, San Jose, and Victorville.
"Marketwide, overall we're getting better, but there are pockets that are getting worse, including cities in California," Fabian said.
Still, he said, "it would be very surprising to see more than a handful of communities" default on their bonds.