There is no free lunch with bank loan funds. In 2001 and 2002 bank loan funds gained just 1.59% and 0.64% respectively, due to the recession and a high level of defaults. The bottom decile-rated funds lost -1.26% and -2.48% in 2001 and 2002, respectively. This year, Berry says the great risk is that "there is not enough yield generated by the funds to offset any losses due to new defaults."

The majority of bank loan funds are continuously offered, closed-end funds. Investors can only redeem shares quarterly. By contrast, the open-end bank loan funds offered by Fidelity, Eaton Vance and Franklin must keep more money in cash than do their closed-end cousins to meet redemptions. The tradeoff: Holding more cash lowers the yield.

Adjustable rate mortgage (ARM) funds, which are considered ultra-short-term bond funds, invest in adjustable rate mortgage bonds. They are yielding around 3% and typically sport durations of less than one year.

On average ARM funds, like bank loan funds, have not had a down year over the past decade. ARM funds' beta values are just 0.09 to the Lehman Brothers ten-year Government Bond Index.

"ARM funds are not as subject as other mortgage funds to prepayment risk," Berry added. "They are considered a slightly higher-risk alternative to money market funds."

ARM funds, however, are not risk-free. Fund managers can't just buy and hold ARMs. They must make portfolio changes to avoid bonds with mortgage prepayments. Plus, they must respond to changes in interest rates.

For example, in 2003 the AMF Adjustable Rate Mortgage Fund had to deal with rapid mortgage prepayments. So the fund reduced its holdings in GNMA ARMs that traded to high premiums. Similarly, the fund increased its holdings in lower dollar, cost-structured ARMs. It also increased its holdings of AAA-rated nonagency securities to diversify its credit profile.

Now that interest rates are on the rise, Jon Denfeld, co-manager of the fund, says he is still defensive. He has invested 60% of assets in six-month ARMs tied to the six-month LIBOR. As rates rise, the mortgage pools within the bonds are reset monthly until the bonds' rates are fully reset in six months. As a result, the duration of his fund is now just one-third of one year. At this writing, the fund was yielding 2.25%. But it was expected to rise another 100 basis points if the Fed raised rates.

"Only time will tell if rates will rise rapidly on the forward curve," he says. "It is difficult for us to change the portfolio on a dime, but this portfolio is structured defensively."

Another option: Adjustable rate preferred stock (ARPS) pays quarterly dividends tied to the U.S. Treasury bill rate. In the event of a bankruptcy, preferred stockholders get paid before common stockholders, but after bondholders.