Should You Follow the "Bond King" Out of Treasuries?

It's been a rough year for bonds investors. Bond prices, which move in the opposite direction of interest rates, were bound to decline once rates hit a record low.

The 10-year Treasury note has jumped to 2.7% from 1.9% at the start of the year.

With Federal Reserve "tapering" on the horizon, near-term bond declines are looking more and more likely. This has led many income investors to dividend-paying stocks, and while dividends should be a big part of your portfolio too, you can still win in bonds.

The Bond King moves away from Treasuries
Famed "Bond King" and PIMCO fund manager Bill Gross has made headlines recently after the media discovered that he is turning even more bearish on Treasuries.

Gross reduced Treasury holdings in his PIMCO Total Return ETF (BOND) by 4% in August alone while increasing mortgage-related holdings. This fund is down almost 4% this year, as bonds have suffered greatly, but I think investors should follow Gross out of Treasuries.

Here's where you should be moving your money and why.

If not Treasuries, then what?
This bond market is unique, and it will require an unconventional strategy. In recent interviews , Gross laid out a bond investment plan that I feel makes sense for this market.

In short, the typical bond strategy of diversifying through maturity dates -- i.e., having both long-term and short-term bonds in a portfolio -- while holding only Treasuries won't work in this market. Instead, investors should stick with shorter maturities for now, reducing their risk of price declines as the Fed draws down its quantitative easing.

Instead of diversifying through maturities, let's diversify among (non-Treasury) bond "classes." There are simply better risk-reward options than long-term Treasuries right now, and this will likely drive capital to these investment alternatives.

Here are a few investments that could work with this game-plan -- one of which Gross is buying himself.

The Bond King Cometh -- to the CEF market, that is
Bill Gross recently made two big insider purchases of a fund that he manages, PIMCO Corporate & Income Strategy Fund (PCN) . This fund invests heavily in corporate bonds with shorter maturities, which is exactly what Gross has recommended buying. Gross made two large purchases totaling more than 1.5 million dollars.

We should consider following him for two reasons. First, safety: A buy like this reduces the risk of Treasuries and longer-maturity bonds. Second, it provides upside beyond yield, as a close-ended fund provides the opportunity for capital gains.

A close-ended fund, or CEF, is similar to a mutual fund. The big difference is that there is only a limited number of units available, so shares, like equities, gyrate depending on supply and demand. Perhaps the PIMCO Corporate & Income Strategy Fund is currently trading at a relative discount due to the panic in the bond market?

The fund doesn't technically trade at a discount to net asset value; it's much closer to its NAV than it was during the good ol' days. The fund trades at a 4.46% premium to its NAV, but that's nearly 10% closer to its value than it was last year. At the same time, while it has become more attractive in price, the fund still pays out an annual dividend yield of more than 8%, and it has a monthly distribution.

I think betting on corporate bonds with short maturities, like Gross has, makes sense. The fact that it's a CEF also gives it a better yield than a typical corporate bond fund.

If you agree with my strategy but want to avoid CEFs, you may want to consider the Vanguard Short-Term Corporate Bond ETF (VCSH) as another alternative to Treasuries. While this fund only pays a 1.92% yield, that's still nearly 50% higher than its Treasury counterpart, and it has a tiny 0.1% expense ratio. This fund holds a diversified group of bonds with maturities in the range of just one to five years. While it holds 99% of its assets in corporate bonds, ranging from JPMorgan to GE , no single firm holds more than 1% of assets.

This investment isn't sexy, but it could provide you safe income until Fed tapering ends. Its price has only swung about $2 in share price this year, even amid bond market panic, because of the short maturity dates of its holdings.

Foolish conclusion: It's time to be choosy
We're likely entering a period where bonds will be less predictable, as they were prior to 1980 . Bonds are getting riskier, but you shouldn't skip them altogether. Rather, I think income investors just need to be choosier.

Income investors should stick to bonds with lower maturities until the economic crutch of monetary stimulus has been completely removed. I also recommend reducing exposure to Treasuries and seeking out better risk-reward alternatives such as CEF bond funds, dividend-paying stocks, and short-term corporate bonds.

Other Ideas for the Income Investor
For years, bonds provided investors with unmatched security. With choppier waters ahead for the bond market, income investor's should consider adding dividend stocks to their portfolio. The Motley Fool's special free report " Secure Your Future With 9 Rock-Solid Dividend Stocks " outlines the Fool's favorite dependable dividend-paying stocks across all sectors. Grab your free copy by clicking here.