The story of the bankruptcy of Vallejo, Calif., reads like an exaggerated version of the script that's got many towns and cities in shaky shape. During the mid-2000s, Vallejo, a Bay Area city of about 121,000, planned for rapid growth tied to the housing boom, took on a pile of debt against homes that didn't get built and got caught short. The borrowing was intended to finance the high cost of Vallejo s police and fire department salaries and benefits, which were estimated to gobble as much as 74% of the city's annual budget.

Vallejo declared bankruptcy in May 2008 and is now working its way out of Chapter 9 with the dubious distinction of being California's largest city ever to go bust. For municipal bondholders, the bankruptcy meant a plan to suspend interest payments on some bonds for three years, leaving investors deprived of income, but more confident that they'll ultimately be repaid. In the latest development, the bankruptcy court handling the case set a deadline earlier this month for bondholders to press their claims.

Vallejo s story illustrates how, despite the rising concern over the security of the municipal bond market, even an almost worst-case scenario leaves bond owners at the head of the line to be made whole.

The bond market evidently believes it will at least repay its municipal debt owners. Owners of a 2003 $1.8 million unrated bond issue at 6% saw the bonds drop in value as the legal machinery engaged. They dropped to 61.9 to the dollar at a 19.8% yield in April 2009. They're now trading at 90.3 at a 7% yield.

"I would take it as something of an accomplishment by Vallejo itself that the bonds are trading so high," says Don Bellante, a professor of economics at the University of South Florida and a co-author of a critical 2009 report by the Cato Institute on the Vallejo bankruptcy. "The bond market seems to think it's highly likely they will receive everything that they expected to receive."

Investors who hold the bonds, either individually or through a mutual fund, have probably seen the worst pass, says Michael McDonough, an investment adviser in Roseville, Calif., who has clients who own the bonds, which are still paying interest. He says the special assessment district bonds, which weren't rated, had a value-to-lien ratio of 3.73 to 1, which he said warranted some investor caution.

"Nonrated bonds should not be scary," he says, partly because many bond ratings are outdated and don't reflect the current, post-bust conditions that could affect their repayment. "Always check that the valu- to-lien ratio is in excess of four or five to one three to one is an absolute minimum. If something looks too good to be true, it probably is."

McDonough says most small investors should concentrate their muni exposure in mutual funds and seek guidance from knowledgeable financial advisers if they try to strike out on their own. Chasing high yields, for example, isn't a strategy he recommends.

"If you do start wanting to put money into a portfolio, get someone who knows what they're talking about," he says.

The combination of the housing bust and an earlier belief that rising tax revenues would be able to fund sweet deals for the police and fire departments was a damning combination for Vallejo. David Denholm, president of the Public Service Research Foundation and another author of the Cato report, says bondholders may come out less banged up than other players in the Vallejo story, but he worries that they'll have too much company as other municipalities stagger under high debt loads and are burdened with public sector union costs.

Ultimately, Denholm says the people of Vallejo got hurt worst. There have been sharp cutbacks in police and fire services, and taxpayers "will undoubtedly pay more in interest the next time they want to float a bond."

"It's repeating itself over and over again, and while I doubt it will drive every [financially troubled city] to bankruptcy, Vallejo could be a bellwether and not an isolated instance," he says. "That's coming down the pike in a lot of states and municipalities."