Municipal bond mutual funds reported another healthy slug of new money last week as demand for high-quality fixed income continued to drive investment flows. Muni funds that report their figures weekly posted a net inflow of $728.4 million during the week ended Aug. 25, according to Lipper FMI.

That represents a minor dip from the preceding two weeks, each of which saw at least $900 million in new money entrusted to the weekly reporting funds. Still, it is the eighth straight week of positive flows.

Weekly reporting funds have reported outflows only three times since the beginning of last year. All funds, including those that report their figures monthly, have been reporting inflows at an average rate of $1.16 billion a week the past four weeks — the most robust pace since March.

“Municipal bond mutual fund inflows continue to display an unprecedented degree of retail demand for lower-risk tax-exempt income,” Alan Schankel, managing director at Janney Montgomery Scott, wrote in a report last week.

The unprecedented degree of demand began early last year.

Investors stuffed $69 billion of new money into municipal funds in 2009, according to the Investment Company Institute, and an additional $19 billion in the first half of 2010.

ICI data shows that flows resumed their torrid pace in August, averaging more than $1.2 billion a week the past four weeks.

With state and local government debt rallying most of the summer, market gains on municipal bonds are now driving most of the growth in the muni fund industry. Municipal bond prices have spiked 4.2% this year, based on the S&P AMT-Free National Municipal Bond Index.

According to Lipper, about two-thirds of the growth in the muni fund industry’s assets in 2009 came from inflows. The other third was attributable to market gains on bonds.

This year, muni mutual fund assets have grown by almost $54 billion, to a record $518.35 billion. Nearly half of that growth — $25.69 billion — has come from market gains. The rest has come from inflows. Market gains over the past month have accounted for nearly two-thirds of the growth.

The interest in municipal debt coincides with a massive rush of money into bonds in general. An incredible rally in bonds has been prompted by mild inflation, if not the specter of deflation, constrained credit growth, weak economic prospects, and minimal risk appetites.

The yield on the 10-year Treasury bond is down 135 basis points this year, and the yield on the 30-year is down 112 basis points.

Trading in inflation-protected Treasury securities implies an expected average inflation rate of about 0.2% over the next five years.

The roughly $2.5 trillion bond mutual fund universe has reported at least $7 billion in new money each of the last five weeks, according to ICI.

Schankel points out that fund-flow data is more meaningful for municipal bond funds than for other types of fixed income. While institutional buyers dominate the daily trading in Treasuries and corporate bonds, he said retail investors remain the most important buyer of municipals. Thus, muni mutual fund flows are a better proxy for demand than fund-flow data for taxable bonds, he said.

Mutual funds own 17.7% of the $2.83 trillion in outstanding state and local ­government debt, according to the Federal Reserve. They own 10.1% of ­outstanding corporate bonds, and 3.3% of Treasuries.

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