Growth in the municipal bond market slowed in the third quarter as financial market turmoil increased, issuers sold less debt, and retail investors pared down their holdings.

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The Federal Reserve reported last week that municipal debt outstanding totaled $2.669 trillion at the end of September, up 0.2% from $2.664 trillion at midyear.

The market's growth represented a slowdown from recent quarters. The market grew at a 0.8% rate in the second quarter, a 0.9% rate in the first quarter, and a 2.2% rate in the fourth quarter last year.

Greater muni holdings by commercial banks and insurance companies offset a decline in holdings by households and money market funds, according to the Fed's flow of funds data.

Households - by far the biggest holders of munis - owned $905.4 billion at the end of September, down from $917.7 billion at the end of June. Money market funds shed more than $26 billion in muni debt, bringing the sector's holdings to $477.8 billion at the end of the quarter.

The Lehman Brothers Holdings Inc. bankruptcy in mid-September combined with bond insurer downgrades, widespread deleveraging, and forced selling have sapped demand for munis.

Issuers have suffered higher borrowing costs and a less-receptive market for debt.

New-issuance volume shrank 5% in the third quarter from the same quarter a year ago, according to Thomson Reuters, mostly reflecting a drop in new-issue volume of more than a third in September.

The Fed numbers released last week do not include the past two-and-a-half months, which have been an extraordinarily volatile period for the municipal market.

Volume dropped by half in October and shrank 22% in November from year-ago levels.

Many market participants agree fat yields on muni debt will eventually lure buyers back into the market.

Municipal Market Data put the yield on a 10-year, triple-A rated muni at 4.21% on Thursday, or 160.7% of a Treasury bond with the same maturity.

The yield is 60 basis points richer than a year earlier, when the 10-year yielded 90% of a Treasury.

Most say the industry now hinges on retail buyers because many hedge funds and institutional investors are bogged down in their own financial woes.

Retail buyers so far seem content to leave their money in safe and liquid investments, such as certificates of deposit and money market funds.

AMG Data Services on Friday reported clients pulled more than $1 billion from municipal bond mutual funds in the seven days ending Dec. 10.

Muni mutual funds' assets have shrunk 10% to $338 billion since the beginning of October, AMG said.

George Friedlander, managing director and fixed-income strategist at Citi, pointed out in a report last week that as of the end of June, investors had $8.4 trillion stored in money market funds, CDs, and other short-term instruments.

The cost of staying in these safe investments is becoming too severe, he said.

As the interest rates on the instruments continue to plummet, Friedlander said people will eventually look for handsomer returns on higher-yielding investments, such as munis.

The interest rate on an average five-year bank CD has compressed from nearly 4.2% toward the end of the summer to 3.62%, according to Money market funds yield an average of 2.34%.

Friedlander said he expects munis to rally "when the worst of the economic crisis is, at the very least, in sight." That may not be for a while, he noteded.

"The patterns that brought us to this point are still in play," he said. "By early next year, however, we would expect additional support to show up, because muni market yield distortions have become so extreme."

Timothy J. Feeney, a financial adviser with Lane Bridgers Associates LLC, said money will start pouring back into the muni market around the end of the first quarter.

"The spreads are way out of line," he said. "As soon as any kind of confidence returns, people will go right back to munis."

Weekly issuance in the fourth quarter has been rocky, ranging from $842 million in the first week of October to $8.3 billion four weeks later.

So far this quarter, issuers have sold $60.14 billion of new bonds. Issuers sold more than $75 billion in the first two months of the fourth quarter of 2007 alone.

The Bond Buyer's 30-day visible supply, which measures the dollar-volume of new bonds slated to come to market, hit a near-record of more than $21 billion earlier this month.

As issuers rushed to sell paper before the end of the year, the new supply has contributed to a further depression in bond prices.

The Bond Buyer 40-bond Municipal Bond Index on Friday was at 91-15, down from 111-21 a year ago. The yield to maturity hit 6.56%, up from 4.83% on Dec. 12, 2007.

"There's a supply overhang that is going to take a while to soak up," said Brian Lehky, a portfolio manager at Dana Investment Advisors. "At some point, we're going to find an equilibrium. ... The yields are staggering."

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