As an income investor, 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 the past 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, from the same period last year.

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

Wal-Mart (NYSE: 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.

This 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 U.S. 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 not
The solution is an asset class known as bank loan funds. These funds buy pieces of loans made by major banks such as JP Morgan (NYSE: 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, then 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 (NYSE: EFR), which invest in these floating-rate bank loans and offer steady yields of about 6%.

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 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 a 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.

Valuations are creeping up as investors catch on to this sector. In the first two months of this year alone, bank loan funds attracted $10 billion, according to Morningstar. That puts them on track to surpass by far the record $16 billion of inflows for all of 2010. If inflation accelerates and rates increase, then senior loan funds are likely to see more popularity.

Action to Take –> If you invest now, then you might be able to earn a nice capital gain in addition to a high yield and added safety from inflation.

P.S. — If you’re an income investor, why would you buy a stock yielding 2% when you can find one paying 26% right here? Watch this presentation for more.