UPDATE 1-Municipal bond market contracts slightly in Q4 -Fed

WASHINGTON, March 7 (Reuters) - The amount of outstanding U.S. municipal bonds dropped slightly in the fourth quarter of 2012, to $3.714 trillion from $3.719 trillion in the third quarter, according to Federal Reserve data released on Thursday.

States, local governments and agencies raced to refinance their bonds throughout 2012, taking advantage of record low interest rates, while new issuance fell off over the course of the year.

The household sector dropped $238.1 billion in municipal bonds in the fourth quarter, after shedding $221.9 billion in the third quarter. It was the largest decline in individual investors' holdings in at least two years, according to the U.S. central bank's quarterly Flow of Funds Accounts.

Mutual funds continued to sweep up the bonds in the quarter, although at a slower rate. They acquired $69.9 billion, after buying $107.2 billion bonds in the third quarter. Exchange-traded funds added $4.0 billion in the fourth quarter.

At the end of the year, President Barack Obama and Congress considered limiting the tax exemption for interest paid on municipal bonds as a way to boost revenues during their negotiations on avoiding the "fiscal cliff" - automatic cuts in government spending and increases in tax rates that were set to kick in on Jan. 1 if an agreement could not be reached.

Unsure of the tax status of their bonds, investors fled the market. While bond funds had seen steady inflows for most of 2012, they reported large weekly net outflows in the final days of the year, according to Lipper, a unit of Thomson Reuters.

In the fourth quarter, insurance companies mostly dropped their municipal bonds. Property-casualty insurance companies shed $4.2 billion in municipal bonds after acquiring $1.8 billion in the third quarter. Life insurance companies dropped $3.4 billion, after buying $4.7 bllion municipal bonds.

Banks acquired $44.4 billion in municipals, roughly half the $90.7 billion they took on in the third quarter, the Federal Reserve data showed.

While the federal government did not cap the tax exemption, and the chairman of the House of Representatives Ways and Means Committee has signaled he is not interested in changing the tax break, issuers of municipal bonds remain on alert. Last week, mayors and civic officials pressed Congress and the administration to keep the tax exemption, saying they would have to pay billions more in borrowing costs if it were changed.