Bonds are divided into a several categories, and it is possible to get substantial diversification within a bond portfolio alone.
Bonds may be categorized into several types. There are investment grade bonds which are conservative and safe, high-yield bonds which are relatively risky and profitable, floating rate bonds whose coupon rate is not fixed, zero coupon bonds which only pay at maturity, and foreign bonds, and so on.
In general, though, there are three main types of bonds: Government Bonds, T-Bills (munis) and Notes.
These are regarded as the safest type of bond since they are backed by the full faith and credit (and taxing power) of the US Government. In fact, when evaluating the risk and return of a stock, or the current spread in the bond market, the current yield on a Treasury Note is called the “risk-free rate.”
The government uses these instruments to borrow money from citizen investors for a year (known as Treasury Bills or T-Bills); 2, 3, 5, or 10 years (Treasury Notes); and 10-30 years (Government Bonds). The coupon is usually very low compared to other bonds, but this is the price you pay for the safety of your assets.
The repurchase of government bonds is sometimes used to introduce liquid currency into the market, which has the effect of also lowering interest rates, and this is known as Quantitative Easing.
Issued by municipalities, these bonds are slightly riskier than government bonds.
In recent economic turmoil, several cities have become bankrupt, and for this reason it is important to pay attention to the credit rating of all bonds. Cities do not default very often, and many people were very surprised to learn that it could happen. Municipal bonds are also exempt from federal taxes, and local governments can sometimes make them completely tax-free.
If you purchase a municipal bond from another state, however, you will probably not receive a tax break from your local government. If you live in San Francisco and purchase a New York Bond , you will still pay the state taxes on that bond.
A company often needs to borrow money to finance its development, and it can be advantageous to do so through the issuance of bonds.
Corporate Bonds usually have higher coupon rates than government bonds or munis, because it’s generally more likely for a company to go bankrupt than a municipal or federal government. The difference in coupon rates between corporate bonds and government bonds with the same maturity is often referred to as “the spread”.
Obviously, the heightened risk comes with an increased rate of return. Companies with high ratings can issue “investment grade” bonds, while companies with lower credit rating issue “high yield” or “junk” bonds.
Is There Anything Else I Need to Know About Bonds?
What Percentage and What Kind of Bonds Should I Have in My Portfolio?