Municipal bond mutual funds coughed up more cash last week as investors continue to take their money out of state and local government debt funds at a record pace.

Municipal funds reported an outflow of $1.42 billion for the week ended Dec. 29, according to Lipper FMI.

While smaller than the outflows reported the previous three weeks, mutual funds continue to face redemptions from investors, threatening to exert selling pressure on a market just recovering from a dramatic sell-off last quarter. Investors have redeemed $16.6 billion from municipal funds in the past seven weeks.

Lipper considers the most important indicator of trends in fund flows to be the average weekly flow over the past four weeks. By this measure, outflows hit a new record pace last week, as the four-week average hit an outflow of $2.68 billion.

Even the financial crisis saw a more benign pace than this. Before last month, the record for the heaviest rate of outflows was $1.8 billion a week, set in 2000.

In his daily commentary on Thursday, Thomson Reuters analyst Randy Smolik noted some encouraging pillars forming in the municipal market. Supply remains extremely light, with only a handful of small deals pricing last week and less than $1 billion of new bonds slated to sell this week. As reinvestment money comes in this month, it will likely have to chase bonds in the secondary market, supporting prices, he said.

The "only caveat," Smolik warned, is negative fund flows. Mutual funds normally have to sell bonds to raise cash when met with investor redemptions.

Cash flows from investors into mutual funds were a major ballast for the municipal market for most of 2009 and 2010. According to the Investment Company Institute, investors entrusted $69 billion to municipal bond mutual funds in 2009 and an additional $32 billion the first 10 months of last year.

Flows abruptly turned negative in November, just as the market began to grapple with extraordinarily heavy supply. Municipal governments issued $132.1 billion of debt in the fourth quarter, the second-heaviest quarterly supply in municipal history, according to Thomson Reuters. The record was set in the second quarter of 2008, when municipalities sold $55.95 billion of variable-rate demand obligations to refund auction-rate securities that had failed en masse.

The heavy supply and fund redemptions took a toll on the market, with municipals delivering a negative 4.7% return for the fourth quarter, according to a Standard & Poor's index, and the yield on the 10-year triple-A Municipal Market Advisors scale spiking about 50 basis points.

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