NEW YORK--A flurry of selling in municipal bond ETFs this week prompted one of the market's largest exchange-traded fund sponsors to temporarily stop redeeming shares for cash. The move underscored how hard-pressed frantic sellers became in the heat of this week's selloff.

State Street Global Advisors, the asset management arm of State Street Corp. (STT), told market participants Thursday that it would only accept so-called "in kind" redemptions for its suite of muni-bond ETFs, according to Tim Coyne, State Street's global head of SPDR ETF capital markets. Mr. Coyne said that State Street hadn't resumed allowing dealers to swap seven of its ETFs for cash on Friday.

The move doesn't directly affect end investors who are selling the ETF shares in the open market.

In bouts of strong selling, certain broker-dealers deliver blocks of ETF shares to their issuer, who then retires unwanted shares from the market. In return, dealers generally take ownership of the underlying bonds from State Street, Mr. Coyne said. For a fee, dealers can instead take cash from State Street, which then sells the bonds back into the market.

On Thursday, selling bonds became so difficult and expensive that State Street disallowed the option for dealers to take cash. For State Street, the risk was that unloading bonds could eat into investor returns, or cause the ETF's price to veer from its underlying index, Mr. Coyne said.

Allowing only in-kind redemptions let ETF traders sell shares easily despite an underlying market caught in gridlock.

For dealers, in-kind only redemptions could potentially pinch those forced to take illiquid bonds onto their books.

Mr. Coyne said State Street's portfolio manager alerted dealers of the change, stressing that redemptions were available at all times on an in-kind basis.

"Our priority is to protect the existing shareholders in our product," Mr.Coyne said. "Redemptions were not stopped at all. Our standard procedure worked perfectly," he said.

Debt issued by states and local governments, like all bonds, has been hit hard in recent weeks amid concerns about rising interest rates. That selloff intensified this week after Federal Reserve Chairman Ben Bernanke echoed that the central bank could pare back its monthly bond-buying efforts should economic conditions improve.

The relevant State Street securities are the $2 billion SPDR Nuveen Barclays Short Term Municipal Bond (SHM); the $1.1 billion SPDR Nuveen Barclays Capital Municipal Bond (TFI); the $232 million SPDR Nuveen S&P High Yield Municipal Bond (HYMB); the $102 million SPDR Nuveen Barclays California Municipal Bond (CXA); the $97 million SPDR Nuveen Barclays Build America Bond ETF (BABS); $32 million SPDR Nuveen Barclays New York Municipal Bond ETF (INY) and $12 million SPDR Nuveen S&P VRDO Municipal Bond ETF (VRD).

On Thursday, traders rushing out of muni bonds resulted in "fire-sale prices," said Jeffery Timlin, a managing director at investment-management firm Sage Advisory Services.

"Once people come in and need their money, even if there's not a bid, [ETFs] have to sell their bonds. There's no flexibility," Mr. Timlin said. "In this market, everybody is a seller, and there's too many people trying to exit at the same time."

Write to Chris Dieterich at christopher.dieterich@dowjones.com;

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