Record municipal bond mutual fund redemptions have emerged as a threat to the rally most market participants expected to kick off early next year, as the anticipated slowdown in the supply of new bonds is met with a wave of selling by mutual funds.

During the week ended Dec. 22, investors yanked $2.9 billion from their municipal bond mutual funds, according to Lipper FMI. Investors have withdrawn $15.2 billion from municipal funds over the past six weeks — the biggest loss of cash over any six-week period in history.

While few mutual fund managers expected the robust pace of inflows the industry saw throughout 2009 and most of 2010 to last forever, the momentum has turned sharply negative.

Lipper's preferred measure of the pace of outflows is the average weekly outflow over the past four weeks. That number is now at an average outflow of $2.5 billion a week — the most rapid pace of outflows since Lipper started keeping track in the early 1990s.

Many analysts have been looking forward to January for a respite from the painful confluence the municipal market has seen in the fourth quarter.

Mainly, the very heavy supply of new bonds is expected to subside. The market had trouble digesting the more than $130 billion of municipal debt sold so far in the fourth quarter — the second-highest quarterly total ever.

This indigestion is evidenced by the negative 4.6% return on municipal bonds thus far in the quarter, according to a Standard & Poor's index measuring returns, and the 50 basis point spiral-up in the yield on the 10-year triple-A rated municipal bond, based on the Municipal Market Advisors yield curve.

Supply has been unusually light the past two weeks. This week's calendar consists of a solitary $525,000 deal from a school district in Oklahoma.

That light supply is expected to continue into early next year, both because of normal seasonal patterns and because a significant amount of borrowing that otherwise would have transacted in early 2011 was pulled into 2010. Not only did borrowers intent on using the Build America Bonds program have to rush to borrow this year because the program is expiring, but many issuers reportedly hurried to market with tax-exempt deals to take advantage of the siphoning effect BABs had on tax-exempt supply. Most forecasts for issuance next year are significantly below this year's total.

But the boost from a supply lull might not be recognizable if mutual funds are selling $2.5 billion of bonds a week.

The market has enjoyed extraordinary demand from mutual funds for almost two years now. Investors entrusted $69 billion to municipal funds in 2009, according to the Investment Company Institute, and through the first 10 months of this year bestowed an additional $32 billion.

In fact, the argument that it was mutual fund outflows that drove the sell-off in municipals could be just as compelling as the supply argument.

Mutual fund redemptions started coming in during the week ended Nov. 17, according to Lipper. By then, the MMA 10-year yield was up only 14 basis points for the quarter and returns on municipal bonds since the end of September were negative 1.4%.

The drastic spike in yields came after mutual funds began dumping their holdings. Plus, the Nov. 11 Standard & Poor's downgrade of $22 billion of tobacco bonds reportedly triggered massive selling among mutual funds in advance of the outflows.

At any rate, the municipal bond mutual fund industry is shrinking fast. Since peaking 10 weeks ago at $527.8 billion, the municipal fund industry has relinquished $14 billion to investor redemptions and $19.4 billion to market losses on bond holdings.

The combined $33.5 billion of lost assets has shrunk the industry by 6.3% in those 10 weeks, to $494.5 billion.