With treasury bonds, certificates of deposit (CD) and money market funds, like the PIMCO Enhanced Short Maturity ETF (ARCA:MINT), still yielding next to nothing, income seekers have continued to flock to a variety of non-traditional dividend sources. While REITs, MLPs and equity driven dividends have become common place, in a variety of portfolios, one superstar bond manager has recently made some big bets on an often forgotten about bond type. For regular investors, following his lead could offer some big dividends and capital appreciation. (For additional reading, check out An Introduction To Corporate Bond ETFs.)
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The Bond King's Bet on Housing
When it comes to the debt markets, PIMCO's Bill Gross is considered by many to be the authority on bonds. The manager oversees nearly $1.2 trillion worth of assets at PIMCO, including his signature PIMCO Total Return A (PTTAX), which is one of the largest mutual funds in the world. So when he makes a move tweaking his funds, its pays for regular investors to heed his advice. Recently, the bond guru has been increasing $245 billion of Total Return fund's exposure to mortgage backed securities (MBS). Gross increased the fund's percentage of assets devoted to the bond variety by six percentage points, to stand at 38% at the end of last quarter.

These bonds are essentially asset-backed securities that are secured by a mortgage or collection of mortgages. The reputation of MBS bonds took a huge hit when the housing bubble burst in 2008 and the fed's took over Fannie Mae (OTCBB:FNMA) and Freddie Mac (OTCBB:FMCC). Along with the Government National Mortgage Association (Ginnie Mae), these entities are responsible for the bulk of the countries secondary mortgage market. While Ginnie Mae bonds are the only MBS variety that are backed by the full faith and credit of the U.S. government, both Freddie and Fannie's bonds implicit government guarantees, especially since the federal take-overs. (For more, read Fannie Mae, Freddie Mac And The Credit Crisis of 2008.)

There could be some method to Bill Gross' madness. A variety of analysts now point to the MBS sector as being incredibly cheap, when compared to sovereign debt. In addition, investors are compensated for the added risk by gaining extra yield. Ginnie Mae bonds have the same guarantees as treasuries, but yield more. More importantly, recent "fed speak" from New York Fed President, William Dudley, highlighted the fact that "if additional asset purchases were deemed appropriate, it might make sense to do much of this in the mortgage-backed securities market." Gross could see some nice capital gains for all those mortgage bonds.

Following Gross' Lead
For investors, adding some exposure to the MBS market could provide some extra yield, as well capital gain growth. While the individual market place for these bonds can be kind of tricky, a broad approach is best. The 800 pound gorilla in the sector is the iShares Barclays MBS Bond (ARCA:MBB). The ETF tracks 236 different Freddie, Fannie and Ginnie Mae MBS bonds and has around $4 billion in assets. The fund has very little exposure to adjustable-rate mortgage (ARM) style mortgages and has a 12-month yield about 3.42%. Similarly, the iShares Barclays Agency Bond (ARCA:AGZ) offers a basket Federal Home Loan Bank bonds, as well as Freddie and Fannie MBS.

Investors looking for less interest rate risk can use the Vanguard MBS Index ETF (Nasdaq:VMBS). The fund tracks bonds with dollar-weighted average maturity of three to 10 years. The yield is less than the iShares fund, currently at 2.19%. The SPDR Barclays Cap Mortgage Backed Bond (ARCA:MBG) allows offers exposure to shorter durations. (For related reading, see Managing Interest Rate Risk.)

Finally, for those investors who think the commercial real estate could continue to see growth in the months ahead, the CMBS sector might be worth a gamble. The PCM Fund (NYSE: PCM) holds a variety of commercial mortgage-backed securities and yields nearly 9%. However, like most of PIMCO's CEFs, the fund does trade at a premium to its NAV.

The Bottom Line
Bond King, Bill Gross' recent return to the MBS market could signal a revival in the bond type. With higher yields, some government guarantees and the potential for capital gains, the sector could be an interesting addition to an income portfolio. The previous funds, along with the Nuveen Mortgage Opportunity (NYSE:JLS), could make good buys.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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