(Reuters) - The possibility of rising interest rates rocked the U.S. municipal bond market on Thursday, with prices plunging in secondary trade, investors selling off the debt, money pouring out of mutual funds and issuers postponing nearly $2 billion in new sales.

"The market got crushed," said Daniel Berger, an analyst at Municipal Market Data, a unit of Thomson Reuters, about the widespread sell-off.

Yields on top-rated 10-year bonds and highly rated 30-years on Municipal Market Data's benchmark scale both spiked 20 basis points.

Those on 10-years ended the day at 2.48 percent, the highest since October 2011, while those on 30-years closed at 3.78 percent, the highest since December 2011. Yields move inversely to price. Berger said it was the largest one-day yield increase since December 2010.

"It's a bit of a follow-through from the market's disappointment from what they were hoping to get from the Fed and a continued reflection to the fragile state of fixed income markets," said Jonathan Lewis, chief investment officer for Samson Capital Advisors.

On Wednesday, Federal Reserve Chairman Ben Bernanke said the central bank could soon reduce its bond buying if the U.S. economy shows signs of strength. The comments sent the yield on the U.S. 30-year Treasury bond to its highest level since September 2011. Municipal bonds often follow Treasuries.

Even before Bernanke's comments, investors had been pulling out of the $3.7 trillion bond market, worried the era of low interest rates was near an end and the central bank would begin "tapering." Since May 1, yields on triple-A bonds have risen by 80 basis points on 10-years bonds and by 99 basis points on 20-years.

The turmoil rippled through the primary market, with four sales totaling $1.763 billion postponed on Thursday due to market conditions.

"Given recent volatility and heavy supply in the market, the city intends to remain flexible on the timing of the sale," said James Lanham, deputy city treasurer for Philadelphia, which moved its $400 million general obligation bond sale to an undetermined date.

Most likely issuers will wait for the market to stabilize in the next few days or weeks before coming back.

Even though rates are rising, they are still relatively low and "very attractive for borrowing," said Darci Doneff, managing director in underwriting and trading at Piper Jaffray.

But rising rates could finally bring an end to the surge of refinancing that has lasted more than a year, she said. For the year through the end of the May, refundings totaled $87.52 billion, compared with only $56.5 billion in new money sales.

"That could be a significant drop," said Doneff. "That could be a major impact on the forward supply."

A SHOCK FOR MOM-AND-POP INVESTORS

In the last month, investors have sold off longer-term bonds to buy shorter-term debt and retail buyers have pulled money out of municipal bond mutual funds, which have seen declining returns the last two months.

The funds reported $2.22 billion of net outflows in the week ended June 19, up from $1.6 billion of outflows in the previous week, according to data released by Lipper on Thursday. It was the biggest outflow since the week ended December 19.

In the last four weeks, outflows amounted to $5.4 billion.

"We've continued to have a weaker June in munis from this tapering talk," said Chris Alwine, head of municipal bonds at The Vanguard Group, which has $100 billion in assets. "Our view is that the market has over reacted to this talk."

Since April 30 through June 19, municipal bond funds at Vanguard and PIMCO have both seen returns ranging from -0.19 percent to -3.61 percent. The lower end of that range was all in short-term funds.

Retail investors, often referred to as the "mom-and-pop buyers" because they tend to be retirees, favor municipal bond funds as safe havens.

"Muni bond investors are in for the shock of their lives," said financial advisor Ric Edelman. "For the past 30 years there hasn't been interest rate risk."

That risk can be extreme. A one-point rise in the interest rate could cut 10 percent of the value of a municipal bond with a longer duration, he said.

Many retail buyers, though, are not ready for the change and "when it starts, it will be too late for them to react," he said, adding that he was encouraging investors to look at their portfolio allocation and make changes to protect themselves from interest rate risks now.

LOOMING BUYING OPPORTUNITY

June and July are the peak months of the year for cash flowing to investors from muni bond payments and redemptions. Investors could see the lower prices as a buying opportunity.

"People are no longer thinking reasonably about the value of the market," Lewis said.

Investors are leaving just as municipal bonds grow very cheap. His firm manages municipal bonds for institutional investors, who he said will find the ratios to comparable Treasury securities, which are taxed, appealing.

On Thursday, 30-year municipal bonds yielded 108 percent of similar Treasuries, the highest since August 2012 and far above the average of 99.3 percent.

"With equities selling off significantly now, I would expect to see some support in the Treasury market," said Alwine, adding that would influence the municipal market.

(Reporting by Lisa Lambert; Additional reporting by Caryn Trokie in New York; Editing by Tiziana Barghini and Andre Grenon)