As an investor you are probably already aware that a portfolio needs to be diversified. It is risky to have “all your eggs in one basket” or a small number of baskets. For a bond portfolio diversification criteria could include:
· Issue Diversification — You want to limit the percentage of a single issue in the total portfolio. For example, no cusip should be more than 15% of the portfolio.
· Issuer Diversification — Most municipalities issue different bonds to fund different projects. For example, a city may issue a bond to fund school construction and another bond to fund investment in a utility. If a city defaults on its obligations to its bondholders it is likely to affect the value of all the bonds it issues. Consequently, it is important to limit exposure to any single issuer. This exposure limit might be 15% of the portfolio.
· Geographic Diversification — Many investors choose to buy only tax exempt bonds in their state of residence if they are in a high tax bracket. Investors in a low bracket may choose to buy bonds in many states that provide higher yields, rather than being restricted to only one state. Generally, taxable bonds have higher coupons and therefore yields. Being able to buy bonds in any state gives an investor more choices that should result in a higher overall yield for his portfolio. However, as in the case for issuer diversification, the exposure to a single state should be limited, possibly to 10% of the portfolio.
