When you talk about diversification you hope to spread your money into a variety of investments. By doing so, you are given the opportunity to create the potential for your money to grow while you reduce the risk.
Last week we addressed stocks. This week we'll review the many facets of bonds.
Bonds come in many varieties - both taxable and tax exempt.
With a bond, you are lending your money; it may be to a corporation, a country or a municipality.
Corporate bonds are issued by companies, of all sizes. High grade corporate bonds from major corporations carry high ratings and the interest earned and distributed is taxable. Most high rated bonds are backed by collateral, e.g. inventory, buildings, property, machinery, etc. Because of their relative safety, they will pay a lower interest rate.
High yield corporate bonds pay a higher return because they may be less safe. The company may be having some financial difficulty and the bonds may be backed by a "promise to pay", not real collateral.
Governments issue bonds for many reasons to run their country. Our own U.S. Treasury offers several types of bonds. Sovereign bonds issued by governments outside the U.S. offer international diversification. Because of the solvency of each country, the risk and yield (return) will vary. You will pay taxes on the interest you earn on these bonds.
Municipalities like cities, states, counties, towns all have the ability to borrow money and issue bonds. Again, the solvency of the region will determine how safe your money may be and the interest each will pay. There are several agencies that rate these bonds. AAA is the highest all the way on down to NR, not rated. The U.S. government does not tax the income from these bonds - they are considered tax-exempt.
A bond issued by New York city would be triple tax-exempt to a resident of NYC. He would pay no city, state or federal tax on that bond.
For diversification you would want some taxable and tax exempt bonds.
You would use bonds of different countries as well as different municipalities.
Be $ Smart - use several different types of bonds when building a portfolio.
Bonds can be quite complex. This is a simplified overview.
