Credit is once again the story when it comes to municipal bond mutual fund performance in the fourth quarter, as those that stayed away from lower-rated paper performed the best, fund managers and analysts said.

According to data compiled by Lipper Inc., the higher the quality of the bonds in the mutual fund, the better it fared. Cumulative total reinvested performance for the 53 insured muni funds with $11.2 billion of assets under management was 0.57%. For general muni debt funds — Lipper tracks 248 funds with $82.3 billion of assets under management in the category — the return was 0.07%. For the 105 high-yield funds with $46.9 billion the return was negative 2.51%.

In November of last year, it became clear that several of the large triple-A insurers, and lower-rated insurers ACA Financial Guaranty Corp. and Radian Asset Assurance, had large exposure to the ailing subprime debt market. As a result, the muni market became very credit conscious, and high-yield funds suffered.

Where high yield faltered, high quality succeeded.

“We have always skewed towards very high quality because historically we are of the opinion that credit spreads in the municipal market are not what they should be,” said Warren Pierson, senior portfolio manager of Baird Advisors, a subdivision of Robert W. Baird & Co. “Our feeling is that you don’t get paid for taking a lot of credit risk in the municipal market. So that really worked for us during this year and especially in the fourth quarter when you saw credit spreads widen considerably.”

Pierson’s Baird Intermediate Municipal Bond Fund ranked as the second best performer in the fourth quarter and for the year, with total returns of 2.07% and 4.92%, respectively. In tallying returns, Lipper said that total returns are figured after expenses and before loads.

Every fund manager of a top fund interviewed noted that high quality was the key to success throughout the turbulent quarter, but two funds in particular had unique investment styles that stood out.

First, the JPMorgan Tax Aware Real Return fund, which was ranked number one in terms of total return in the fourth quarter, uses an inflation hedge.

“The [fund’s] goal is to provide tax efficient inflation protected return,” said Deepa Majmudar one of the fund’s two portfolio managers. “Nominal muni bonds carry inflation risk and lose value in rising inflation. During the fourth quarter of 2007, despite the weakness in the U.S. economy, inflation risk persisted due to high oil and commodity prices, weakening U.S. dollar and risking cost pressures from various sources.”

The fund is hedged using consumer price index-linked bonds that rise and fall in value as CPI is reported each month.

“The CPI index jumped over 4% on an annual basis and as a result the market priced in higher inflation expectation along the curve,” Majmudar continued. “The inflation hedge in the fund benefited from these market movements.”

In the forth quarter the TARR fund had a total return of 2.26% and led the pack.

Only helping the situation, the fund also had a portfolio made up of 75% triple-A credits and 18% double-A credits, according to Morningstar Inc.

Another surprise in the Lipper data is that one of the new municipal bond exchange-traded funds made the list of top performers for the quarter. State Street Global Advisor’s SPDR Lehman National Municipal Bond ETF had a total return of 1.91% and is ranked as the fifth best performer in the last three months of 2007.

“We happen to be benched against a very high quality index in terms of the broader market,” said Tim Ryan, portfolio manager for the ETF. “We can only invest in double-A or higher and we don’t have bonds subject to the alternative minimum tax, housing bonds, hospital bonds, or tobacco bonds.”

In an ETF, the portfolio manager is a passive investor, using a sampling method to track an index and aims at tracking the returns of the index. Therefore, with the Lehman index in double-A or higher, the ETF is as well for the most part.

Low fees were also mentioned by fund managers with high returns. The Baird fund charges 30 basis points and the SPDR ETF charges 20 basis points. According to Morningstar analyst Sonya Morris, the average fee for a municipal bond mutual fund is 64 basis points. The JPMorgan fund charges 65 basis points.

Another main point that successful managers this quarter noted was insurer exposure. Managers said it was key to determine to which bond insurers the portfolio would be exposed.

Pierson said that he actually overweighted himself in Texas paper backed by the state’s Permanent School Fund to have access to enhanced bonds, but avoid insurer exposure. He said of the 18% of his portfolio that is insured, the majority was backed by PSF.

“This is a rough estimate, but from what I understand for every dollar that PSF has of capital, they insure two dollars, but for an MBIA [Insurance Corp.] or Ambac [Assurance Corp.] for every dollar they have of capital, they insure $140 or $150 of bonds. That puts PSF in a great position, they are a viable insurer of debt.”

Ryan said the ETF also considered this issue. Earlier in 2007, he said State Street looked at the triple-A monoline insurers generally as one sector, but by November, they began to separate out insurers. Without naming names, Ryan said that he is overweight in some and underweight in other, depending on how the market views each one.

The 25 worst performers among muni funds in the quarter were high-yield funds.

“Whoever has more exposure to high yield in going to be a poorer performer,” said Troy Willis, senior portfolio manager at OppenheimerFunds. “There is fear and uncertainty in the market place and under those circumstances high yield is just going to get worse. So in that type of market, the farther you go down the rating scale, the harder it is to get a good bid. Remember, there was not default that occurred, it was just market sentiment on the insurers.”

For Pierson, the muni market should not be about high yield in any market environment.

“We get clients who have made a lot of money and are now looking to protect the capital,” he said. “Our clients are rich and invest in munis because they want to stay that way. That is why we are positioned in the high grade sector in the intermediate part of the yield curve and we think it is what wealthy individuals and institutions want.”

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