20 funds to hedge against deflation

First, let's look at municipal bonds, which should increase in value as other interest rates decrease in a deflationary environment. They are free from federal taxes, and buyers who live in the issuing state also may get a break on state taxes. However, without diversification, holders run the risk of the municipality hitting financial problems. National municipal bond funds offer less of a tax advantage but more safety.

Many municipal bonds would not perform well in destructive, run-for-the-hills deflation, because issuers would have more trouble making payments. However, in a deflationary period marked by sluggish growth, investors would probably do well in high-quality municipals, according to Paulsen.

The classic deflation hedge is a position in government or high-quality corporate bonds, especially with longer terms. Because longer-term bonds have a higher yield as overall interest rates decline, a nominal yield is effectively worth more, says Adam Leone, an adviser with Modera Wealth Management. On the other hand, many investors don't want to bet the farm on deflation, so they buy Treasury inflation-protected securities, or TIPS, more volatile bonds that hold their value if deflation turns to inflation.

Deflation tends to lift a currency's value, so just holding dollar-denominated assets, like money market funds, is another hedging strategy, says Jack Ablin, the chief investment officer at Harris Private Bank. Investors may earn next to nothing, but their cash gains more purchasing power in a deflationary environment.

Another way to hedge against deflation is to invest in foreign debt. Emerging-market economies would be intriguing in a deflationary environment because they would have inflation and could let their currencies rise "to rebalance the world a little," Ablin said. "That could be a home run."

Investors looking to bet on deflation with equities should stick with high-quality, dividend-paying companies that can maintain pricing power, as well as capitalize on and gain market share in a tough environment, according to Leone.

This article was reported by Elizabeth Trotta for SmartMoney.