Municipal bond yields tumbled to a record low Friday as constrained supply coupled with the prospect of a protracted period of low interest rates to prod more investors into state and local government debt.

The yield on the benchmark 10-year triple-A municipal bond closed Friday at a record 2.54%, based on the Municipal Market Data scale. The previous mark of 2.56% was established Thursday.

Municipals have been treading in rarefied territory in recent weeks. They matched the previous record low of 2.57% for 10 of 11 days before breaking through Thursday and showed no signs of slowing down Friday, traders said.

“The market still feels pretty good here,” a trader in New Jersey said. “You continue to achieve new levels. … We’ve been entrenched as buyers for a while.”

The $2 billion iShares S&P National AMT-Free Municipal Bond Fund, an exchange-traded fund seeking to replicate returns on the Standard & Poor’s national muni index, closed up 0.13% on Friday.

The Standard & Poor’s total return index is up 5.2% this year.

Market participants report a drastic shortage of tax-exempt municipal supply — a scarcity that has helped buoy prices much of this year.

Until last year, municipalities rarely pushed more than 10% of their debt through the taxable market.

This year, about a third of state and local government borrowing is being channeled into the taxable bond market because of the Build America Bonds program.

Based on figures from Bloomberg LP, municipalities have floated $150.7 billion of tax-exempt debt this year, compared with $176.6 billion at this point last year, $182.9 billion in 2008, and $210.9 billion this point in 2007.

Demand for tax-exempt paper, meanwhile, remains rampant. Municipal bond mutual funds, which generally are captive buyers of tax-exempt debt, have commanded $23.8 billion in new money this year, according to Lipper FMI. They now manage $509 billion.

“We can’t stress enough the positive price impact that the Build America Bonds program has had on tax-exempts, as it consistently lowers available tax-exempt supply,” Citi municipal strategist John Dillon wrote in a report last week.

Another trader in New Jersey said any tax-exempt bond with decent ratings that becomes available is snapped up fast. There is simply not enough paper available for people looking for tax-free income, he said.

“We’re having a very hard time finding stuff for our clients,” the trader said. “It’s mind-boggling to me.”

A Labor Department report Friday that the economy shed 131,000 jobs last month — leaving the unemployment rate changed at 9.5% — did nothing to alter the perception that interest rates are poised to remain low well into next year.

A year ago, the consensus of analysts surveyed by Bloomberg was that the Federal Reserve’s target for the federal funds rate would be about 1% by the end of 2010. There is now almost unanimous belief it will remain unchanged at a range of zero to 0.25% this year, according to Bloomberg’s survey.

Persistent weakness in the economic recovery has begun to shape expectations about interest rates even into next year. The consensus forecast for the federal funds rate at mid-year 2011 has tumbled 100 basis points since the beginning of this year, to about 0.65%, according to Bloomberg.

Pacific Investment Management Co.’s Bill Gross told Bloomberg Radio on Friday he thought the Fed could stay on hold for two or three years.

Expectations for low interest rates are clearly reflected in Treasury yields, which continue lower all along the curve. The 10-year Treasury yield plunged eight basis points Friday to 2.82%. The two-year Treasury is now just 0.5%, down three basis points on the day and 63 basis points on the year.

The second trader in New Jersey said the perception that the Fed’s target for interest rates is indefinitely on hold is dissuading municipal traders from dumping inventory. Even if someone doesn’t really want to be long municipals, the trader said, the incentive to sell off his position is minimal, given that it has been so long since the muni market last had a bad day.

The last time the triple-A 10-year yield jumped by more than one basis point was June 15.

Randy Smolik, a municipal analyst with MMD, in market commentary last week said investors who previously had been resisting reaching out into longer-term debt have begun to capitulate.

“As more investors embrace the prospect that low rates are here to stay, the steep muni curve that has developed over the past couple of months is ­tempting buyers to longer maturity purchases,” he said.

Vincent Harrison, a portfolio manager at Dupree Funds, said he has had a very rough time finding bonds in the 20-year range, which is where he likes to put money to work.

“We’re not really being able to buy stuff on the long end where we used to,” said Harrison, who runs eight municipal funds with $1.2 billion in assets. “The supply’s gotten a lot tougher to find over the last week, week and a half. … Basically, I can’t find any 20-year paper.”

The triple-A 20-year has strengthened 13 basis points since the end of June, according to the MMD scale.

Smolik cited “selectively stronger” trades on Friday.

He pointed to escrowed-to-maturity Massachusetts Bay Transportation Authority paper maturing in 2018 trading at 2.12%.

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