The Long-Term Inflation Trade

06/07/2011 7:00 am EST

Focus: STOCKS

Carla Pasternak

Editor, The Income Investor

With experts still warning about inflation on the horizon, one asset class offers relative safety if inflation does materialize, but also delivers income and growth potential even if it doesn't.

You’re a short-term trader. But you probably have long-term accounts too, right? For the investing portion of your portfolio, should you be worried about inflation?

You bet.

On an annual basis, prices were up 2.7% in March. That’s the highest mark since December 2009.

Cotton prices are up more than 170% in about a year. Oil had increased by 40% through mid-April. Copper, corn, and wheat prices registered double-digit gains in the first three months of 2011 alone.

In the past six months, Kraft Foods (KFT), Kellogg Co (K) and McDonald’s (MCD) have all put through price increases to consumers. Nike (NKE) and Whirlpool (WHR) have done the same.

Walmart (WMT) CEO Bill Simon has said he thinks inflation “is going to be serious.” He warned that recent transportation-related cost hikes will be passed through to shoppers.

That means the amount of income you’re earning may not keep pace with how much prices are rising—especially if you are retired and living on a fixed income.

If you own long-term bonds, such as 30-year US Treasuries, you could see their prices fall dramatically as yields rise to keep pace with inflationary expectations.

This is what I’ve been telling my High-Yield Investing subscribers. I’ve also been telling them to look into what I think is the perfect solution if inflation rises…and a good place to keep your money, even if it doesn’t.

The Perfect Asset Class If Inflation Strikes (or Doesn't)

That solution is an asset class known as bank loan funds. These funds buy pieces of loans made by major banks such as JPMorgan Chase (JPM) to large corporate borrowers.

The loans are issued at floating rates, which reset every 60 to 90 days. So if inflation increases and interest rates rise, you’ll benefit from earning higher rates. And even at current low interest rates, I’m finding securities, like the Eaton Vance Floating Rate Fund (EFR), that invest in these floating rate bank loans and offer steady yields of around 6%.

Here’s a daily chart:

chart
Click to Enlarge

But what if inflation isn’t a problem and interest rates don’t rise dramatically to battle it?

Worst case, you would be paid to wait, reaping high yields of 6% for your patience. At best, you would receive both high yields and capital gains as inflation expectations ramp up.

Are there risks to this strategy? Yes. A double-dip recession triggered, say, by oil prices rising to $150 per barrel, could lead to higher default rates and a decline in the price of bank loan funds. Still, this may be a risk worth taking while you can still find funds trading at a discount to their historical valuations.

Those valuations are creeping up as investors catch on to this sector. In just the first two months of this year, bank loan funds attracted $10 billion, according to Morningstar. That puts them on track to far surpass the record $16 billion of inflows for all of 2010. If inflation does accelerate, and rates increase, senior loan funds should only see more popularity.

With this strategy, you might be able to earn a nice capital gain in addition to a high yield and added safety from inflation.

See related: 5 ETFs That Profit from Inflation

By Carla Pasternak of Dividend Opportunities

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