10 Bond-Fund Refuges From Stagflation - TheStreet

The price of petroleum has slipped back in recent days, but talk of stagflation hasn't. According to Google news searches, 3,392 articles mentioned the dreaded "S word" in the week ended July 23, up from an average of 906 for each of the four previous weeks.

The "stag" -- for stagnation -- in stagflation translates into a major detour in the road to corporate profit growth, making equity investments far less likely to pay off. The S word's "flation" suffix -- for inflation -- can prove a killer for hopes of achieving returns on bond funds that exceed the acceleration in the cost of living. Stagflation is defined as a period of rising inflation and sluggish growth.

With the more traditional economic contractions, "cash equivalent" investments such as short-term Treasury bills or money market mutual funds provide refuge from crumbling equity valuations. But stagflation even tarnishes the appeal of money market instruments, as the inflation component of that economic malady can exceed short-term returns, thus eroding their purchasing power.

For those believing that the bear market isn't finished and that stagflation remains a threat, we parsed TheStreet.com Ratings fixed-income fund database for bond funds that might insulate investors from the insidious impact of economic stagnation combined with inflation.

Stability and preservation of capital were the primary considerations in filtering the database for open-end bond funds with characteristics would help investors who feel threatened by stagflation:

Positive returns for the latest year as well as for the more difficult investment period of 2008 to date (through June 30).

Stability, as measured by annualized 12-month standard deviations of returns of less than 2% (which contrasts an average of 2.51% for all bond funds).

Current dividend yields of at least 3%, for payouts that stand some chance of neutralizing the erosive impact of inflation.

Preservation of principal in order to assure adequate asset bases for payment of future dividends; with the 10 bond funds meeting the above criteria and having the highest 12-month "principal changes" selected for the list.

The accompanying list of bond funds meeting the above constraints borders on the extreme of capital preservation.

Half the listed funds demonstrate their conservative investment postures by including "government" in their respective names. A sixth, the

Performance Funds Short-Term Fixed Income Fund


lacks the word in its name, but in fact is 65% invested in short-term government securities.

Similarly, with the prospect of inflation posing the most threat to longer-term instruments, nine of the 10 funds specifically state in their names that they stand on the short end of the yield curve. The only member of the table without "short" or "limited term" or "limited duration" in its name is the

CNI Charter Government Bond Fund

(CGBAX) - Get Report

, which is, in fact, invested in short and intermediate government notes.

The current dividend yields of the funds in the group, ranging from 3.19% for the

Dreyfus Short-Intermediate Government Fund

(DSIGX) - Get Report

to 4.47% for the

Lord Abbett Investment Trust Short Duration Income Fund

(LALDX) - Get Report

, are unlikely to cover the full impact of inflation.

But because the fund managers have selected portfolios that have been appreciating in "principal" value, the funds -- while slightly riskier than Treasury bills and most money market funds -- offer reasonable hope of immunizing their holders from the erosive impact of inflation.

With every member of the list, the fund's annualized one-year standard deviation of returns -- which reflects the annualized range within which 68% of its monthly fluctuations fall -- is less than its one-year growth of principal. This raises the odds that the funds have hope of maintaining total returns sufficient to withstand the impact of stagflation.

While the dividend yields on these "principal preservation" bond funds might seem a bit anemic, investors are emphatically cautioned to resist the temptation to rush to bond funds with lofty yields in hopes of conquering inflation.

Suppose someone was convinced a year ago -- when the incipient subprime mortgage issue was just starting to cause some doubt about the viability of the financial industry and the sustainability of the bull market -- that the economic expansion would be fall into stasis with, at the same time, inflation gaining momentum.

Someone with that knowledge might have been tempted to park assets in bonds paying high yields. Big mistake!

An adjoining table shows the bond funds from TheStreet.com Ratings database with the highest dividend yields as of a year ago.

Even though the average fund on that list paid a dividend yield of 8.2%, the longer-term, lower-quality funds lost sufficient "principal" value to bring their average total investment return down to a negative10.88%. Not only did it not in any way provide any insulation from the gathering inflation, it turned out almost as poorly as the "risky" S&P 500, which tumbled 13.12% over the same stretch.

Even more damaging than the disappointing average total return of the group was the 17.91% diminution in the average "principal" value of the funds. This lowered the asset basea upon which the funds in the group depend for generating future dividend returns.

The lesson: when inflation threatens, the bond funds of choice are those with relatively short maturities, conservative portfolios and low volatility.

Richard Widows is a senior financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.