The balance sheets of some states and municipalities remain in financial straits. But while most of the media’s coverage focuses on localities in those states, such as Florida, Nevada and California, that suffered the most during the real estate downturn, many other states and localities are emerging from the downturn with their finances intact.

That outcome has enabled the market for municipal bonds to rebound in recent quarters, overcoming doomsday predictions made by analysts such as Meredith Whitney and a number of other high-profile analysts.

Over the past two years, tax revenue has stabilized in most municipalities, and has even begun to grow in some localities.

State and local governments raked in $1.29 trillion in taxes in 2010, about 2 percent less than they collected in 2008. State tax receipts improved in every quarter of last year, reflecting tax increases, steadier property values in many parts of the country and a recovery in consumer spending.

Meanwhile, hefty spending cuts have closed the budget gap for fiscal 2012 in 42 states and the District of Columbia. Additional cutbacks may be necessary to avoid future shortfalls, but many municipalities appear to have the problem firmly in hand.

Although local governments face undeniable challenges, conditions have improved to the point that investors can comfortably assume a bit more risk in the municipal bond market. Even so, investors should continue to steer clear of the riskier bonds issued by California and other cash-strapped states.

In April of last year, we added Market Vectors Pre-Refunded Municipal Bond (NYSE: PRB) as a way to pick up some extra yield while assuming little additional credit risk. The exchange-trade fund’s (ETF) portfolio is comprised of pre-refunded and escrowed-to-maturity municipal bonds. All of its holdings are secured by escrow accounts or trusts that contain US government bonds.

At the time of initial recommendation, the ETF was paying a tax-equivalent yield of almost 3 percent while generating about the same amount of volatility as Treasury bonds. Since then, however, the yield on the fund has fallen to about 1 percent and its price has declined as investors abandoned the ETF for riskier fare. As a result, we’ve decided to swap out of this ETF for a more advantageous play.

Sell Market Vectors Pre-Refunded Municipal Bond.

In its place, we’re adding Market Vectors Intermediate Municipal Index (NYSE: ITM) to our Income & Hedges Portfolio.

The fund’s portfolio holdings have an average duration of 6.4 years, so its longer duration would normally be subject to greater interest rate risk. But given the Federal Reserve’s commitment to maintain a low interest rate environment through 2013, interest rate risk is not an immediate concern. The ETF also steers clear of revenue bonds related to infrastructure assets or tobacco settlements, two areas of greatest potential risk, and it doesn’t employ leverage to boost returns.

The ETF does take on more credit risk than our former position, with many of its holdings among the lower A-rated bonds. Again, this shouldn’t be a significant concern since revenue at many municipalities is stabilizing and there hasn’t been a significant bump in municipal defaults over the past few years. That greater credit risk does boost the fund’s average yield to 3.4 percent, however, and offers exposure to price appreciation as investors continue take on additional risk. Finally, the fund sports a low expense ratio of just 0.24 percent.

Buy Market Vectors Intermediate Municipal Index under 25.