As investments, bonds and certificates of deposit (CDs) have some similarities. They’re both low-risk, low-return options for people who want to preserve their capital. However, despite these similarities, there are some important differences to keep in mind.
CDs tend to be safer than bonds because they’re insured by the Federal Deposit Insurance Corp. (FDIC). On the other hand, bonds are slightly riskier but offer slightly higher returns. You can also sell most bonds to other investors if you need to cash out your investment early. With a CD from your local bank, you typically can’t cash out early without paying a penalty fee.
Read more to find out about the major similarities and differences between bonds and CDs as well as how they can fit into your portfolio.
What Is a Bond?
A bond is a debt security that investors can purchase from other investors or directly from the organization issuing the bond. When an organization, such as the federal government, a local government, or a company, wants to borrow money, it can do so by issuing a bond.
Investors who choose to lend money to them will purchase bonds from the organization issuing the bond.
When an organization issues a bond it will choose an interest rate (also called a coupon) and maturity for the bond. The interest rate determines how much the borrower will pay to investors each year. The maturity date determines how long the bond issuer will continue to make interest payments and when the bond issuer will return the investor’s loan.
For example, a company may issue bonds with an interest rate of 4% and a maturity of 30 years. The company promises to make two interest payments each year.
If an investor buys a $1,000 bond, they will give the company $1,000 in exchange for the bond. The company will then make two $20 payments to the investor each year until the bond matures. Once the bond matures, the company will make a final interest payment and return the initial payment of $1,000 to the investor.
Over 30 years, the investor will receive $1,200 in interest payments and ultimately get back the $1,000 they lent to the company.
Investors who do not want to hold a bond until it matures can sell the bond to other investors.
The price of the bond will depend on its face value (the amount the investor will receive when the bond matures) and its interest rate compared with the current market rate. In general, rising rates reduce the value of existing bonds while declining rates increase the value of existing bonds. The effect is more pronounced on bonds that are farther away from their maturity dates.
There are many different types of bonds, each with unique characteristics.
Treasury bonds are issued by the U.S. government. They are among the safest bonds available. As a result, they offer some of the lowest interest rates available on bonds.
Corporate bonds are issued by companies that want to borrow money to finance continuing operations or to help them expand. These can range from high-grade, low-risk bonds to very risky bonds with high interest rates, depending on the stability and credit rating of the company.
City governments can issue municipal bonds, or “munis,” to help pay for public projects like improving local infrastructure. Some investors choose municipal bonds because they offer tax advantages. Returns are tax-free at the federal level and may be tax-free at the state and local levels, depending on where you live.
High-yield, or “junk,” bonds are the riskiest type of bonds. They offer the highest interest rates but are issued by organizations experiencing instability or with a poor history of repaying their loans. Investors who choose the right junk bonds can earn good returns, but there is the risk that the bond issuer will default.
Risks of Bonds
Before you invest in bonds, it’s important to understand the risks.
When you lend money to someone, whether it’s to a friend or by buying a bond issued by a company or government, there is a chance that the borrower won’t repay the loan. If that happens, the borrower is said to have defaulted on the loan.
Investors who buy a bond from a borrower that later defaults won’t receive future interest payments or get back the money they lent to the borrower.
Interest Rate Risk
When you buy a bond, the interest rate of the bond is typically locked in. However, interest rates in the market are constantly changing. If you buy a bond when rates are low and rates then rise, you’ll still have a bond paying a low interest rate. This can reduce the value of your bond if you need to sell it to another investor before the bond matures.
Inflation is the process by which money loses purchasing power over time. Because you’re receiving fixed interest payments each year from a bond, inflation reduces the value of those payments with each passing year. If inflation rises significantly, the purchasing power of each interest payment you receive could be dramatically reduced.
If you want to sell a bond before it matures, you need to find another investor willing to buy it from you. There’s always the chance that no one will be willing to buy the bond, forcing you to hold it until maturity. This is called liquidity risk.
What Is a Certificate of Deposit?
A certificate of deposit, also called a CD, is a time deposit account. You can open a CD at a bank.
When you open a CD, you’ll choose a maturity date for the CD, typically ranging from six months to five years from the day you open the account. You’ll also decide how much money to deposit in the CD.
The bank will pay interest to your CD account based on the amount you deposited in the CD and the interest rate it is offering. Typically, CDs with longer terms pay higher rates than those with shorter terms. With most CDs, the interest rate is locked in for the life of the CD when you open the account.
One major perk of CDs is that they are insured by the FDIC. Such deposit insurance helps protect customers in case a bank fails. This makes CDs far less risky than bonds, but also means they pay lower interest rates.
The FDIC offers up to $250,000 in insurance per depositor, per account type at covered banks. You can increase your FDIC protection by splitting your balance between multiple banks, keeping the balance at each below $250,000.
When a CD matures, you’ll have the opportunity to either withdraw your money from the account or add additional funds. If you make no changes, most banks will roll your account’s balance into a new CD automatically.
If you want to make a withdrawal from your CD before it matures, most banks will charge a penalty fee. The size of the fee is usually based on the amount of interest you earn in a day and it typically increases as the term of the CD gets longer.
|Bonds vs. CDs|
|Issued by governments, companies, other entities that want to borrow money||Issued by banks|
|Not insured||Insured by the FDIC up to $250,000|
|Investors can sell bonds to other investors if they need their money before the bond matures||Early withdrawals are often available, but may incur a penalty fee|
|Terms range from 1 to 30 years||Terms range from 6 months to 5 years|
One major difference between bonds and CDs is where investors buy them. Bonds are issued by governments and other entities that want to borrow money. You typically need a brokerage account to buy a bond. CDs, by contrast, are easy to open. You can set up a CD at almost any bank without much trouble.
How To Decide Between Bonds and CDs
To decide between bonds and CDs, consider your goals. Do you want a long-term investment that can gain value, or do you simply want to keep your money safe for the short to medium term?
Bonds are Best for Long-Term Investing
In general, bonds are better for investors who want a long-term investment. Bond maturities can stretch from one to 30 years or more and they offer higher interest rates than CDs. This makes them suitable for long-term investors who want to build a diversified portfolio that can weather a downturn in the stock market.
CDs Excel When It Comes to Short-Term Goals
CDs are better for investors who want a short-term way to keep their cash safe. They have lower interest rates than bonds but are virtually risk-free as long as you remain below the $250,000 FDIC insurance limit.
CDs are especially popular among people who are saving for goals like making a down payment on a car or taking a vacation, as CDs make it easy to have money available when it’s needed while keeping it safe and earning interest in the meantime.
Frequently Asked Questions
How do I compare bond yield to CD yield?
To compare bond yield and CD yield, you have to make sure you’re looking at the correct numbers.
Before buying a bond, the important thing to consider is the current yield. This is the bond’s annual interest payments, or yield, divided by its current market value. For example, a bond that pays $50 in interest each year and has a market value of $975 has a current yield of 5.13%.
Before opening a CD, you should look at the Annual Percentage Yield (APY). This is the amount of interest you earn after accounting for things like compounding interest. By comparing the current yield of a bond to the APY of a CD, you can accurately compare the yields of the two.
Is a CD safer than a Treasury bond?
Treasury bonds are backed by “the full faith and credit of the United States government.” The FDIC is an independent government agency that is also backed in the same way by the federal government.
In effect, this gives both equal levels of default risk. If the U.S. government defaults on a Treasury bond, there’s a good chance that it will also struggle to reimburse people who lose money in an FDIC-insured account.
Both CDs and Treasury bonds are exposed to other types of risk, such as interest rate risk and inflation risk. The primary difference in risk between the two comes when an investor wants to withdraw their money prior to the maturity date.
With a CD, the investor has to pay a predetermined penalty for making an early withdrawal. With a Treasury bond, the investor has to find another investor willing to purchase the bond from them. In theory, there could be no investors willing to purchase the bond, while the bank must return the money in the CD to the account holder.
Which type of investment offers both capital gains and interest income?
Investors who open a CD account with a bank cannot sell their CDs to other investors. The only way to get their money from a CD is to make an early withdrawal or wait for the CD to mature.
Investors who buy bonds can sell those bonds to other investors if they want to. The market value of a bond will depend on its face value and its coupon rate compared with market interest rates. If market rates decrease, bond values tend to increase. That means that investors who buy bonds can receive interest payments and sell them for a capital gain.