PIMCO co-founder Bill Gross, the manager of the world's biggest bond fund, is lowering expectations.

In his April investment letter posted on the firm's website on Tuesday, Gross says: Total return as a supercharged bond strategy is fading.

Gross, who runs the 157 billion pounds PIMCO Total Return Fund
, says investors should get used to smaller investment returns because of slower global growth and as the financial services industry continues to deleverage, or reduce its reliance on derivatives and borrowed money to generate higher returns.

Gross didn't stop with bonds. He said stocks returning between 6.5 percent and 7 percent after inflation -- now popularly called 'Siegel's constant' after business professor Jeremy Siegel -- are fading as well. And levered hedge strategies based on spread and yield compression are fading, too, he added.

In his letter entitled The Great Escape: Delivering in a Delevering World, Gross writes that investors should not desert bonds if annual returns hover around 4 percent instead of 10 percent. He says that bonds should remain critical components of an investor's portfolio.

The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets, Gross said. Breaking out of that 'jail' is what I call the Great Escape.

In light of this new reality for investing, Gross says he favours high-quality, short duration and inflation-protected bonds. He also likes dividend-paying stocks like Merck & Co. and Johnson & Johnson -- with a preference for developing over developed markets. He also favours commodities whose prices rise with inflationary pressures and are in limited supply.

In an ultra-low interest rate climate where global growth and inflation would stay mild, investors must take risk in some form, Gross wrote.

Clinging to near-free assets such as Treasury bills would mean earning an inflation-adjusted return of minus 2 percent to 3 percent, Gross said.

For his part, Gross increased the Total Return Fund's exposure to mortgage-backed securities (MBS) to 52 percent in February from 50 percent in January. In October, the fund's exposure to MBS was just 38 percent.

Gross has been steadily ploughing into MBS on the expectation that the Fed would announce a new round of mortgage bond buying.

At the same time, derivatives -- financial instruments that derive their value from another security -- have long been a staple of the trading strategy in PIMCO's Total Return Fund to generate some of the fund's returns.

Reuters discussed PIMCO's usage of these esoteric instruments in a Special Report in February.

Last month, Gross addressed the issue of PIMCO's reliance on derivatives.

In the March note entitled Defense, Gross says from 1980 to 2011, the firm employed an offensive strategy that utilized prudent derivative structures to generate consistent alpha.

In the note, he said the firm, for the time being, was shifting to a more defensive posture in light of the heightened risk that remains in the world financial markets. As part of that new strategy, Gross says PIMCO will de-emphasize derivative structures that are fully valued and potentially volatile.

PIMCO, short for Pacific Investment Management Co., is a subsidiary of Allianz and oversees $1.36 trillion.

(Additional reporting by Richard Leong, Editing by Chizu Nomiyama)