A recent Merrill Lynch publication advises high-net-worth clients to buy municipal bonds, pointing to the increasing likelihood that taxes will rise for those in higher income brackets and the fact that the flight to safety this year is causing a drop in Treasury rates. Both factors have boosted the relative allure of these investment instruments.

What the report fails to mention is Vallejo, Calif. On May 23, this town of 120,000, across the bay from San Francisco, became the first California city in history to declare bankruptcy. Just as corporations in recent years have sought the bankruptcy court’s help in shucking off unmanageable pension and health care expenses for union employees, the City Council of Vallejo decided unanimously that Chapter 9 was its only way out.

That drastic decision could ignite a torrent of similar moves by cities and counties across the country that have been hit by declining tax revenues and investment returns, in part due to the mortgage crisis. Such a trend could upend the normally predictable municipal bond markets. I have heard from a source close to the situation that several other California cities are watching to see what the judge does in the Vallejo case because they, too, are considering seeking bankruptcy relief.

Vallejo’s City Council was responding to years of mounting deficits, which were projected to reach $17 million in the current fiscal year. The budget gap was swollen by expenditures for police and firefighter salaries and pension funds, which came to account for 76% of the city’s total general fund expenditures. Creditors listed in Vallejo’s Chapter 9 filing include the California Public Employees Retirement System, Wells Fargo, and Union Bank of California as trustees for bonds amounting to $53 million.

The move came after more than two years of trying to negotiate with the city’s unions, which in late May offered last-ditch proposals to cut costs, including reducing salaries and eliminating funding for vacant positions. (That last item makes you wonder about municipal management. Why wouldn’t you eliminate funding for vacant positions?)

The decision of Vallejo’s leadership to throw the city on the mercy of the courts was not taken lightly. The city’s circumstances are unique, but perhaps not so unusual. Vallejo was once home to the Mare Island Naval Shipyard, which over time built some 500 ships, including several nuclear submarines. The shipyard was closed in 1996 as part of a larger effort to streamline military spending. The city has suffered a consequent falloff in revenues, spurring its current economic hardship.

A staff report presented to the City Council in May put average police officer compensation, fully loaded with benefits, at $191,060, while firefighter pay with benefits was estimated at $193,174. These are heady numbers, agreed to in a period of prosperity. The unions, needless to say, are not happy. They have until June 27 to contest the filing in federal court.

Many other cities have budget difficulties, and it is possible that some of them will follow Vallejo’s lead. San Diego, Detroit, and Pittsburgh are just a few of the numerous cities facing substantial underfunded pension liabilities. Many others have seen property values and sales tax revenues drop as the economy has slowed.

“Municipalities in several states are in deep trouble because of the decline in their revenue base,” a longtime municipal bond analyst and columnist, Girard Miller, says. He points out that California is unusual in not having a state apparatus for dealing with troubled municipalities.

In New Jersey, for instance, Mr. Miller says, “There is a very clear provision for the state taking over a city in trouble, and there are remedies in New York.” He also points to Proposition 13 in California as limiting tax increases that might otherwise pull cities like Vallejo out of their mess.

However, the overriding problem Vallejo faces is not confined to California. Officials from Birmingham, Ala., visited legislators in Washington last April, threatening bankruptcy for the state’s most populous county. Jefferson County is struggling with $4.6 billion in debt and might need relief from its bondholders.

States also are battling the rising promises made to unionized workers. According to Standard & Poor’s, pension assets held by Connecticut, Illinois, Rhode Island, Oklahoma, and West Virginia amount to less than 60% of liabilities; 80% is considered the minimum acceptable. The ratings agency says unfunded state pension liabilities total $371 billion, and that unfunded other retirement benefits for 41 states that have quantified them total at least $400 billion.

A recent study by the Government Accountability Office reports that the number of public employee retirement funds that are less than 80% funded reached 42% in 2006, up from less than 10% in 2000. Declining investment returns, combined with the fact that people are living longer and allowed to retire earlier, has weakened the outlook for these plans.

Another issue gaining prominence is the outlook for unfunded health care benefits promised to municipal workers, which the GAO estimates to range between $600 billion and $1.6 trillion (yes, trillion). “The unfunded liabilities are large because governments typically have not set aside any funds for future payments of retiree health benefits as they have for pensions,” Mr. Miller says.

Daniel Solender, the director of municipal bond management at the investment firm Lord, Abbett, says it is too early to draw much of a conclusion from the Vallejo situation, as it has just reached the courts. “This will be a test to see how successful they will be,” he says.

He adds, however: “This is a huge issue. We will have to see what happens. Our main concern is whether investors will be paid. The court documents don’t deal much with the bondholders, but so far they haven’t missed a payment.”

While it may be too early to generalize from the Vallejo situation, the city’s action should alert investors to growing budget problems that may well create risks in the municipal bond markets. Some municipal bond managers shrug off these concerns as having been in existence for some time. So were concerns about CDOs, SUVs, and the other alphabet soup components of the subprime disaster.

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