As the credit markets continue to remain largely frozen to weaker credits, investors are starting to abandon the municipal bond market following several weeks of calm.

The municipal bond market in the United States is no slouch. Total outstanding supply stands at $2.7 trillion dollars with the Merrill Lynch Muni Master Index yielding 4.2% or an 8% taxable equivalent. That’s the highest yield in years for municipal bonds.

Earlier this fall, the municipal bond sector plunged as investors rushed out of weaker credit markets resulting in a short-term panic and causing a major spike in yields that ultimately drew value investors as spreads hit record levels compared to taxable Treasury bonds. But that state of relative calm has ended.

The Port Authority of New York and New Jersey failed to auction $300 million dollars’ worth of taxable bonds on Wednesday as investors balked at riskier credits in the municipal bond sector. Luckily, the bi-state agency doesn’t require immediate funds and can still delve into its existing cash-flow. That’s not the case with other states and municipalities. President-elect Obama has even offered to extend Federal government assistance to those states unable to secure credit market financing.

The growing funding concerns facing municipalities has already spread to several states, including California, which requires cash to finance a massive budget gap in 2009. California, with a long string of budget deficits is now declaring a State of Emergency in December as the state runs out of cash. California is the largest issuer of muni debt.

What’s truly alarming about the scrapped Port Authority offering was the short duration of the fixed-income term of only three years. Investors would typically embrace a short-term note that pays a tax-free yield. But these are not normal times.

Wednesday wasn’t a good day for new tax-free bonds. Most offerings were reduced and their spreads turned out to be higher than planned compared to risk-free Treasury bonds – now trading at their lowest yields since Eisenhower was president.

U.S. municipalities still must raise at least $21.2 billion this month making it the heaviest projected 30-day supply in 2008; the Port Authority’s failed auction also means other deals coming to market either won’t raise enough bids or will be scrapped altogether.

The rating agencies have also confused investors since the market has lost confidence in their ability to accurately rate and rank credit offerings.

As the U.S. economic recession deepens into 2009 it would be advisable to avoid tax-exempt municipal bonds, despite their attractive yields. The risk is too high. You’ve got to believe that many more cities, towns and states will suffer from a credit squeeze coupled by a lack of buyers as revenues continue to decline in a deteriorating economy. Avoid muni bonds.