Published: December 10, 2009

Benjamin Franklin once referred to the magic of compound interest as the "8th wonder of the universe" for its ability to systematically accumulate wealth. Inflation, then, which systematically destroys wealth, must be an evil twin.

Nothing is quite like the relentless rise in the prices of everyday goods and services -- it ravages currency and stifles economic growth. Central governments around the world are on constant guard to keep inflation bottled up -- because once unleashed, it can be extremely difficult to stop.

But we've been bitten by this bug before. Maybe you remember the late 1970s, when the government raised rates to prohibitive levels to combat runaway inflation -- mortgage rates topped 19%.

Could history repeat itself? You bet it could, and the time to position your portfolio accordingly is now.

Back in 1979, you could pick up a stamp for 15 cents, a loaf of bread for 58 cents and a gallon of gas for 86 cents. A new automobile would set you back about $3,500 on average, and a home went for just $63,000. Keep in mind, though, median household income was $16,000 at the time.

Had you invested $10,000 in a brand new 30-year Treasury bond paying 10.7%, the $1,070 in annual interest would have been enough to pay for a year's worth of gas -- with enough left over to buy 100 gallons of milk and 280 dozen eggs.

Clearly, the interest generated by that bond (which would be maturing soon) won't go nearly as far these days.

Do you think it will be any different 30 years from today? If prices continue appreciating at the same pace, brace yourself for gas being $10 a gallon, $20 for a movie ticket, and a whopping million dollars for a decent suburban home.

That in itself is a good argument to steer clear of long-term bonds at the moment; inflation will steadily erode the purchasing power of fixed income payments.

Fortunately, there are ways to turn the tables. In fact, certain asset classes don't just protect against inflation, but handsomely profit from it.

Earlier, we examined the impact of inflation on a Treasury Bond purchased in 1979. But what if for every uptick in inflation, the principal value of that bond had ratcheted higher as well?

Assuming inflation rose +2.5% annually (the long-term average), the bond would now be maturing at $20,975 instead of being locked in at $10,000. That's exactly what Treasury Inflation-Protected Securities (TIPS) are built to do.

First offered in 1997, these unique securities are tethered to a variant of the consumer price index (CPI). Coupon rates are fixed, but the principal value of the bond floats to keep pace with inflation.

For example, a $10,000 bond with a 10-year maturity might offer a modest interest rate of 2.5%. Initially, investors could expect yearly payments of $250. But if inflation rears its ugly head and climbs +5% annually, then the bond would be worth $10,500 at the end of the first year, $11,025 at the end of the second, and so on... eventually maturing with a value of $16,289.

There are several ETFs offering exposure to these securities, the largest of which is iShares Barclay's TIPS Bond (NYSE: TIP). But I give the edge to Pimco ETF Trust 1-5 Year (NYSE: STPZ), in part because its limited portfolio duration means less susceptibility to rising interest rates (for all their perks, TIPS are still bonds and sensitive to rate fluctuations).

Short-term TIPS like those held by STPZ are a pure-play on inflation and have the strongest correlation to changes in the CPI. And the portfolio carries a flawless 'AAA' credit rating to boot.

As a rule, shorter-term TIPS are preferable whenever real yields are rising. There are three primary drivers that could cause this: Fed rate hikes, rebounding economic growth, and higher credit risk for the U.S. government. I think all three are foregone conclusions.

In exchange for inflation protection, TIPS investors must be willing to accept lower yields. But TIPS have had low breakeven rates because of the deflationary environment. Just a few months ago, 10-Year Treasuries were yielding 3.5%, while comparable TIPS were paying 1.8%.

That spread implies expectations for an inflation rate of just 1.7% -- we could easily see the CPI rising at two to three times that pace. STPZ currently yields a shade under 2%. But if you're looking to make sure at least a portion of your assets keep pace with rising inflation, then this is an ideal solution.

If TIPS sound appealing, you're not alone. Along with gold, this sector has been flooded with more new cash than any other during the past few months. The iShares TIPS offering attracted nearly $850 million in September.

Nevertheless, STPZ is an attractive idea for patient investors looking to sleep soundly during inflationary times.

-- Nathan Slaughter
Editor
StreetAuthority Market Advisor
Half-Priced Stocks
The ETF Authority

P.S. -- Remember how TIPS funds were first offered in 1997? Well these revolutionary investment vehicles used to be reserved almost exclusively for Wall Street's elite. But that's changed now. To find out more about these securities, click here.