The municipal bond market continued to grow during the fourth quarter in the face of a global credit crisis as retail investors flocked to high-quality state and local government debt.

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Total state and local government debt outstanding grew to $2.69 trillion at the end of 2008 from $2.671 trillion at the end of the third quarter and $2.619 trillion at the end of 2007, according to Federal Reserve data released last week.

It was the slowest annual rate of growth since 2001, according to Municipal Market Advisors.

Retail investors supported the growth.

Households beefed up holdings of munis by 4.2% during the quarter, to $959.8 billion. Households' holdings of corporate and foreign bonds shriveled 5.2% and stock holdings plunged 23.3%.

Households now own 35.7% of outstanding munis, compared with 34.5% at the end of the third quarter. That figure does not include other types of holders that often invest on behalf of retail investors, such as mutual funds and money-market funds.

Richard Ciccarone, managing director at McDonnell Investment Management LLC, said retail investors flocked to high-grade municipals in search of safe havens.

The fourth quarter was atrocious for stocks. The Standard & Poor's 500 Index plummeted 22.6%. Scary headlines abounded.

The economy shrank 6.2% in the fourth quarter, according to the Commerce Department. The unemployment rate spiked to 7.2% at the end of December, and has since jumped to 8.1%.

Fear chased retail investors out of stocks and into safer climes, Ciccarone said. While this flight to quality largely benefited Treasuries, high-quality munis were one of the perches investors found in search of safety, he said.

"Munis are still considered to be at least much safer investment than equities," Ciccarone said. "To some extent they were doing a flight to quality. ... Allocations went to safer ground."

Daniel Teplitz, a financial planner in Old Bridge, N.J., said he has increased his recommended allocations of fixed-income for clients to 50% from 40%. For tax-paying investment clients, the fixed-income allocation is almost all munis, he said.

Municipal bonds are an easy sell, he said, because clients are scared to keep money in stocks.

Ciccarone said investors made clear distinctions between high-grade and lower-quality paper.

This manifests itself in the large increase in households' holdings compared with shrinking mutual funds' assets.

Some mutual funds hold high-yield munis, Ciccarone said, and many investors likely cashed out of high-yield mutual funds and bought better-quality bonds.

Mutual funds' muni holdings shrank to $388.8 billion from $399.1 billion.

AMG Data Services, which tracks the flow of dollars into and out of mutual funds, reported an outflow from muni funds every week of the fourth quarter. At one point, investors were withdrawing an average of more than $1.5 billion a week, according to AMG.

The Arcata, Calif.-based fund tracker has reported inflows into municipal funds every week since the end of the fourth quarter.

Another trend illustrating investors' more-discriminating taste is the inflow into money-market muni funds, which offer relatively low yields backed by secure, short-term munis.

Money-market funds' holdings of munis swelled to $494.4 billion from $477.8 billion during the fourth quarter.

Ciccarone pointed out that was probably mostly because of the Federal Reserve's support for money-market funds. The Fed launched a facility to protect money-market funds after the $65 billion Reserve Primary Fund "broke the buck" in September - meaning it had less than a dollar in assets for every client dollar invested.

The growth in retail investors' holdings offset lighter holdings at some types of institutional investors.

Commercial banks pared their municipal holdings to $215.6 billion from $223.4 billion.

Brokers and dealers eager to clear inventory shed munis during the fourth quarter, shaving holdings to $38.7 billion at the end of the year compared with $61.9 billion at the end of the third quarter.

"None of these changes were unexpected," Municipal Market Advisors managing director Matt Fabian wrote in a report this week.

One bright spot among institutional investors was property and casualty insurers, whose muni portfolios grew to $369 billion from $365.4 billion.

Municipal bonds constitute 28.7% of property and casualty insurers' financial assets, compared with 27.4% at the end of the third quarter.

At the end of 2004, munis constituted 23.2% of property and casualty insurers' financial assets.

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