After a big bruising since last summer, Bill Gross is buying distressed mortgage-backed securities, excluding subprime debt instruments. He’s also selling Treasury bonds.

The dean of fixed income at PIMCO is loading up on high quality mortgage bonds. For value investors, now is the time to ride the coattails of the world’s best performing bond fund manager as the U.S. government moves to guarantee the country’s largest mortgage lenders. That could mean big gains lie ahead for bonds issued by Fannie Mae and Freddie Mac

PIMCO’s Total Return Fund, which boasts $130 billion dollars under management, now holds 61% of its assets in mortgage debt compared to just 20% twelve months earlier. The Lehman Aggregate Bond Index, the Fund’s benchmark, holds 43% in mortgage debt.

According to Gross, “Government policy is moving to sanctify the status of the government-sponsored agencies…it became a question of which institutions would be sheltered by the government umbrella.” PIMCO is buying mostly mortgage agency debt and avoiding subprime securities, which he describes as “garbage.”

PIMCO’s boss is also avoiding U.S. Treasury debt after making a bet earlier this decade ahead of the dotcom bust and the ensuing recession in 2001. But now, Gross believes Treasury bonds are overvalued as the government, he claims, understates inflation by 100 basis points, or 1 percent coupled by a huge rally following the subprime collapse last July. “If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe-haven has been way overdone. Treasuries are yielding 2 to 3 percent – there’s no real return on that at all.”

I would tend to agree with the Bond King. Avoid TIPs (Treasury Inflation Protected Securities), subprime debt and longer dated Treasury bonds, too. I’d still park my precious liquidity in short-term Treasury debt (up to 12 months) as a hedge against more turmoil in the banking sector, especially among regional banks where a rash of bankruptcies lies ahead.