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Selecting the Best Funds for Deflation

written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 5/24/2010

Which are the best funds for deflation when it hits the economy? Investors need to modify their choices dramatically when these economic situations arise.

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    Effects of Deflation

    Deflation is a general decline in the prices of goods and services. Deflation is bad for most businesses which need the prices for their products to stay level or increase over time. According to an article in Smart Money magazine that ran in 2008, deflation results in "absolutely the worst investment environment". Deflations is considered to be especially bad for the stock market and not too hot for government bonds as the flight to quality drives down yields. Treasury bills and notes already yield less than one percent out to maturities of two years. Investors need to think a little differently to pick out the best funds for deflation.

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    Look for Quality Streams of Income

    If the economy turns deflationary, the best investments and corresponding mutual funds will be those than can provide a stream of income from quality sources. This means high grade corporate bonds and high quality dividend-paying stocks. Investment grade corporate bonds are the safest investment when deflation hits. If your bond fund is paying a dividend of 4 percent per year and inflation is at negative 2 percent (deflation) the real rate of return is 6 percent.

    With stocks you are looking for the same type of quality. Companies that have paid consistent dividends should be able to maintain their payouts and provide a good after-deflation rate of return and prop up the share prices. Look for mutual funds in the growth and income category. There are stock funds that have made it an investment goal to provide a stream of steadily-increasing dividends. These are the types of stock mutual funds that have a chance to provide decent investment returns if deflation hits the economy.

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    Recommended Mutual Funds for Deflation

    Here is a listing of mutual funds that were highlighted in several recent financial articles discussing investing and deflation. For further reading the articles are linked below in the references section. The funds are listed in no order of preference.

    Taxable Bond Funds:

    • Bond Funds:Vanguard Intermediate-Term Investment Grade Fund
    • Loomis Sayles Intermediate Duration Fund
    • Rainier Intermediate Fixed Income Fund
    • Prudential Short-Term Corporate Bond Fund

    Tax-exempt Bond Funds:

    • Vanguard Intermediate-Term Tax-Exempt Fund
    • Baird Intermediate Municipal Bond Fund
    • USAA Tax Exempt Short-Term Fund

    Stock Funds:

    • Eaton Vance Dividend Builder Fund
    • T Rowe Price Equity Income
    • Allianz NFJ Dividend Value

    These funds are just a starting point for investors looking for the best funds for deflation. The investor should take a look at the holdings of the individual mutual funds and how they performed when the market was having bad periods.

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          Final Notes

          Investors should always do their own research when looking for the best funds for deflation. Bond funds should hold bonds of high quality and intermediate duration. A fund with an average credit quality of A to AA and a duration of 3 to 6 years would be a good candidate. Stock funds should own the stocks of companies that can maintain their profit levels and dividend payouts. Smart Money magazine suggested the industries of utilities, consumer staples, health care and infrastructure in the article on deflation.

          A final note for ETF investors. The SPDR S&P Dividend Fund, stock symbol SDY, holds the stocks from Standard & Poors list of "Dividend Aristocrats". The Dividend Aristocrats are companies that have increased their dividend payout every year for at least 25 consecutive years. These sound like the type of stocks and fund to own if deflation hits the economy.