What Is the Difference Between CDs and Bonds?
Certificates of deposit (CDs) and bonds are both considered safe-haven investments. Both offer only modest returns but carry little or no risk of principal loss. They are much like interest-paying loans, with the investor acting as the lender. Many investors choose these options as a slightly better-paying alternative to a traditional savings account. However, they have fundamental differences that may make one a better investment than the other for some investors.
- Both CDs and bonds are considered safe-haven investments, with modest returns and low risk.
- When interest rates are high, a CD may yield a better return than a bond.
- When interest rates are low, a bond may be the higher-paying investment.
Understanding CDs and Bonds
CDs are available from banks or credit unions and function much like savings accounts, but they offer a slightly higher rate of interest. In return, the holder agrees to let the issuing financial institution keep and use their money for a set period. That period can be as short as six months or as long as 10 years. Extended holding periods offer higher interest rates.
CDs are as safe as an investment gets. The Federal Deposit Insurance Corporation (FDIC) guarantees them up to $250,000, so even if the bank should fail, an investor recoups the principal up to that limit.
One risk an investor faces with a CD is inflation. If an investor deposits $1,000 in a CD for 10 years, and inflation rises over those 10 years, the buying power of that $1,000 isn’t what it was at the time of the deposit. CD interest rates rise with the rate of inflation because the bank must offer a better return to make its CDs competitive. Therefore, buying a long-term CD might be a great deal in times of higher interest rates. However, locking in money when interest rates are low will look like a bad deal if the interest rates rise.
In short, a CD is a great place to park some money you don’t need without fear that it will disappear. At worst, the money won’t grow as fast as inflation.
Bonds, like CDs, are essentially a type of loan. The bondholder is loaning money to a government or corporation that issues the bond for a set period in return for a specific amount of interest.
Bonds are issued by governments and companies to raise money. Highly rated bonds are as safe from losses as the entities that back them. Unless the government collapses or the company goes bankrupt, the principal is safe, and the agreed-upon interest will be paid. Also, if a company goes bankrupt, bondholders are repaid before stock owners.
Bonds are rated by several agencies, the best known of which are Moody’s and Standard & Poor’s. The bond rating is the agency’s evaluation of the creditworthiness of the issuer. Many investors won’t go below the top rating of AAA. Lower-rated bonds pay a little more interest, but that comes with additional risk.
A crucial difference between CDs and bonds lies in how they react to increased interest rates. When interest rates rise, bond prices decrease. That means that a bond will lose market value if interest rates rise. That is, if you sold the bond on the secondary market, it would go for less because other bonds would be available that pay a higher rate of return.
No matter what happens in the secondary market, if you buy a bond, the agreed interest will be paid, and it will be worth the full-face value when it reaches maturity.
Special Considerations: Safety and Liquidity
CDs are the ultimate safe-haven investments because the money is insured up to $250,000. U.S. government bonds are also considered very safe. High-quality, highly rated corporate bonds are effectively safe from all but catastrophe.
However, remember that both come with a commitment to a length of time. You may not want to buy a long-term CD when interest rates are low or a long-term bond when interest rates are high. Assuming that the historical trend reverses, as it always does sooner or later, you may be locking yourself into a reduced rate of return.
Both CDs and bonds are relatively liquid investments, meaning that they can be converted back into cash fairly quickly. However, cashing them in before their redemption date can be costly. In the case of CDs, the bank may impose a penalty that eliminates most or all of the promised earnings and may even take a fraction of the principal. In the case of bonds, selling early at the wrong time risks the loss of value and the forgoing of future interest payments.
The wise investor keeps an emergency fund where money is available without penalty. That probably means a regular savings account.