After the epic lows and soaring highs of the stock market over the past year, it s understandable that many people just want something stable in their portfolio an investment that pays them steady income and provides a sense of security. So it s no surprise people have flocked to bond funds, pouring more than a quarter of a trillion dollars into them during the first nine months of 2009. But watch out: Bonds might not offer all that security for much longer. Bond prices fall when interest rates rise, so many bonds lose value at the first whiff of an across-the-board hike in interest rates, something many analysts anticipate happening as the economy recovers. Still, one type of fixed-income investment is paying a decent yield these days and actually could provide even higher returns if interest rates rise: bank loan mutual funds.

Companies, just like people, borrow money from banks all the time for a variety of reasons. Those loans usually have interest rates that reset every 30 to 90 days. When the Federal Reserve raises rates, rates on bank loans generally rise too. Yields recently averaged 6.9 percent on bank loans nearly double that of 10-year Treasurys. Bank loans are also secured by assets and get paid off first if a company defaults on its debts (corporate bonds, on the other hand, are often unsecured). While bonds lose value when interest rates rise, prices for these investments aren t affected, says Scott Page, a portfolio manager at Eaton Vance who manages over $15 billion in bank loans.

We re the anti-bonds, he says. More than two dozen mutual funds bundle these bank loans together and distribute interest to investors monthly. Of course, investing in this type of debt isn t risk-free. The companies that take out these type of loans tend not to have the best credit ratings. They don t always pay back the money, either. Bank loans are defaulting at a 9.1 percent annual pace. That s down sharply from the default rate in early 2009 but only slightly below the rate of corporate junk bonds. Volatility is also an issue. Prices on some bank loans plunged to just 60 cents on the dollar at the height of the credit crisis late in 2008. (They had bounced back to 88 cents by November 2009.) Investment-grade corporate bonds aren t nearly so volatile, points out Eric Jacobson, director of fixed-income research for Morningstar.

With the economy on the mend, though, analysts expect the $500 billion market for bank loans to improve. Analysts forecast that the default rate on bank loans will drop back to around 4 percent in 2010, near the historical average. That could help prices, which tend to rise as default rates go down, says Gunther Stein, chief investment officer for Symphony Asset Management, a large manager of bank-loan funds.

These days the best option for investing in bank loans could be closed-end funds, mutual funds that are traded like stocks (the funds are bought through a broker). Closed-end bank-loan funds are able to offer higher yields, on average, than their open-ended mutual fund counterparts by using leverage and other types of debt to boost returns. One caveat: Closed-end bank-loan funds might hold second lien loans, a riskier form of debt since it s less likely to get repaid in a bankruptcy, says Mariana Bush, a closed-end-fund analyst with Wells Fargo Advisors. Experts say it s best to buy these funds only when they re trading at a substantial discount to their underlying assets. As it turns out, several of them are doing just that.