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Cautious Funds That Pay Rich Yields (Correct)

(Corrects story originally published Aug. 23 to remove reference to Kroger, which the Touchstone fund does not own.)

NEW YORK ( TheStreet ) -- Faced with red ink, investors have been dumping intermediate-term bond funds. The funds have lost 3% this year, according to Morningstar. Rising interest rates caused the losses. When rates climb, bond prices fall as investors sell old issues with small yields.

For better results at a time when rates may continue to climb, consider funds that fall into Morningstar's conservative allocation category. Those funds keep about 30% of assets in dividend-paying stocks and the rest in a mix of different kinds of bonds.

The stock allocations help the conservative portfolios weather periods of rising rates. Stocks often shine when rates climb because the economy is strengthening. This year, the average conservative allocation fund returned 1.9%.

Top choices in the category include Federated Capital Income (CAPAX), MFS Diversified Income (DIFAX), and Touchstone Flexible Income (FFSAX).

Among the steadiest performers is MFS Diversified Income. This year, the fund gained 2.6%. During the past five years, MFS returned 8.2% annually, outperforming 92% of peers. Portfolio manager James Swanson aims to stay broadly diversified by holding five different asset classes. In its neutral position, the fund has 20% of assets in real estate investment trusts, 20% in value stocks, 25% in high-yield bonds, 15% in emerging-market debt, and 20% in U.S. government issues. The asset classes were chosen because they tend not to move in lockstep. This year, high-yield bonds rose when government bonds were sinking.

Swanson overweights categories that seem to be cheap. Earlier in the year, he was 3 percentage points overweight value stocks. But as the market climbed, he shifted to a neutral allocation. When emerging-market bonds sank in recent months, he began to overweight the sector. "The economies in the emerging-markets may be slowing, but the credit quality of the bonds is not going downhill," he says.

Income-oriented investors should consider Touchstone Flexible Income, which yields 4.3%. In comparison, the average intermediate bond fund yields 2.2%. To boost yields, Touchstone has 40% of assets in preferred shares, which pay fixed yields like bonds. Many bonds are considered senior to preferreds. So in the event of a default, bondholders are paid before preferred investors receive anything. As a result, preferreds are riskier and must pay higher yields than senior bonds.
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