Faced with one of the worst quarters for total return in the last five years, mutual fund managers said yield-curve positioning, proper credit selection, and risk aversion in the first quarter of 2008 were key to achieving top rankings - even as the universe of tax-exempt mutual funds totaling $131.7 billion was plagued by a negative 1.89% cumulative results for the three-month period ending Mar. 31, according to new data from Lipper Inc.

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"February was probably the worst month on record," said Jeff Tjornehoj, senior research analyst at Lipper. In January, cumulative total return for all tax-exempt mutual funds was 0.91%, but in February the funds returned a whopping negative 3.47%, while the quarter ended slightly improved with returns of 2.42%, as of March 31, he said.

"March was the answer to a horrific February, but still not strong enough to completely erase the sluggish start of the year," he said.

On Jan. 31, a generic, triple-A general obligation bond due in 2038 yielded a 4.36%, but by February yields were rising and the climate cheapened significantly to 5.14% by Feb. 29, according to Municipal Market Data, and eventually ended the quarter back at a 4.92%.

Municipals remained cheap on a relative and absolute basis throughout the quarter, but especially in mid-February, when the 30-year municipals were yielding more than 100% of the comparable U.S. Treasury yield, Tjornehoj said.

As challenging as it was to navigate through the interest rate environment, fund managers said they maintained low expense ratios and avoided exposure to auction-rate securities after auctions for those investments began to fail in mid-February and that sector collapsed. They also touted low exposure to monoline bond insurers, but sought other high-quality paper as triple-A guarantors were being downgraded at a brisk pace for their subprime mortgage exposure.

Short and intermediate debt funds fared the best - short funds as a group delivering a 0.50% cumulative total return, short-intermediate funds a 0.94%, and intermediate funds a 0.20%.

Tim Ryan, vice president at State Street Global Advisors in Boston, captured first place in the short category with his SPDR Lehman Short-Term Municipal Bond exchange-traded fund - which debuted in mid-October - with a 2.06% cumulative total return.

Ryan used an index strategy to mimic the returns of the Lehman Managed Money Short-Term Index, and said the fund's low expense ratio of 20 basis points, relative high quality, and avoidance of risky sectors produced stellar results among 62 peers.

The short-term index it tracks invests in bonds rated double-A or higher, with one- to five-year maturities, and excludes tobacco, housing, hospitals, airline bonds, and alternative minimum tax paper, he said.

Despite the backdrop of market turmoil, Warren Pierson, senior portfolio manager at Baird Advisors in Milwaukee, said keeping his Baird Intermediate Municipal Bond Fund structured 77% in pre-refunded bonds helped the institutional shares rank in first place with a 1.66% cumulative total return among 166 peers in the intermediate category, and the investor shares rank second with 1.57%.

He also maintained 20% in insured paper and 2% to 3% in cash over the period.

The fund, whose duration is neutral, tracks the Lehman seven-year GO index, which has a five-and-a-half--year duration, according to Pierson. His said his focus on high-quality, non-call paper in the five- to 10-year spectrum, as well as a low expense ratio of 30 basis points for the institutional shares and 25 for the investor shares, also helped boost performance.

High-yield funds were hit the hardest, suffering a negative 3.05% cumulative total return for the quarter. As a result, poor performance was inevitable for funds, like the $6.4 billion Oppenheimer Rochester National High-Yield Fund.

Three share categories of the funds dropped to the bottom of the high-yield category - scoring 103d, 104th , and 105th among 107 peers, according to Lipper. The fund's core holdings underperformed the rest of the market significantly, said Scott Cottier, a senior portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y., and co-manager on the fund.

"It was definitely a rough quarter for us," he said. "When you manage for yield, short-term volatility can sometimes swamp your yield advantage. During times in the credit cycle where spreads widen, that tends to be where our style underperforms."

Still, the fund's distribution yield stands at 7% and it has a 6.4% annualized total return over the last five years as of March 31, compared with just 3.98% for the peer group, according to Lipper.

However, high-yield managers like Frank Lucibella, portfolio manager at MFC Global Investment Management used a combination of credit selection, shorter maturity risk, and increased coupon positioning to boost three shares of the John Hancock High-Yield Municipal Fund that his firm sub-advises to the top of the high-yield ranks.

He took a defensive approach by shortening his maturities to 20 to 25 years from 30 to 35 years in the tobacco and health care sectors, while still maintaining a competitive yield structure.

"It was very much a catch-as-catch-can market," Lucibella said.

The A shares of his fund ranked first with a negative 0.92% cumulative total return, while the B and C shares tied for second place at negative 1.11%.

With so much chaos in the insured sector, those funds delivered negative 1.83% for the quarter amid pricing pressure from the bond insurance debacle.

Clark Wagner, director of fixed income at First Investors Corp. in New York, said because his national insured and New York Tax-Exempt Insured funds held a market weight in different insurers - not an overabundance of any one insurer that sustained credit deterioration - his funds ranked within the top 15 of the category among 54 peers.

For instance, the A and B shares of the $712 million national insured fund ranked in fifth and sixth place, achieving cumulative total returns of negative 0.28% and negative 0.47%, respectively. Wagner said the average maturities of the funds - 11.1 years for the national insured fund and 13.6 years for the New York insured fund - was shorter than the peer group when rates were rising and the yield curve steepened.

His duration also extended - to 6 years from 5.8 years on the national insured fund, and to 5.9 years from 5.7 years on the New York insured fund.

"As long insured rates were moving up, duration extended quite a bit, which was not good, but we extended less than our peers," Wagner explained.

By comparison, the 251 peers in the general municipal debt category returned negative 1.41%.

Steve Winterstein, a managing director at PNC Capital Advisors in Philadelphia, said as the yield curve steepened, he was overweight in bonds maturing between five and 10 years in his PNC National Tax-exempt Bond Fund, while he also kept duration less than five years, and moved available cash into pre-refunded paper.

Additionally, he kept an underweight position in monoline insurers, increased his high-quality exposure, and focused on underlying credit quality.

The institutional shares ranked in first place with a cumulative total return of 1.07%, while the A shares ranked second with 0.94%. Winterstein co-manages the fund with Rebecca Rogers.


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