CDs vs. Bonds: An Overview
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. Both are much like interest-paying loans, with the investor acting as 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.
CDs are available at any bank and function much like savings accounts. They offer a slightly higher rate of interest than a regular savings account. In return for that higher interest, the investor agrees to keep the money in deposit 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 Corp. (FDIC) guarantees them up to $250,000. So even if the bank should fail, the investor can recoup the invested principal up to that limit.
One risk the investor faces 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 rates rise with the rate of inflation. The bank needs to offer a better return to make its CDs competitive. So, buying a long-term CD might be a great deal in times of higher interest rates. However, locking in money when interest rates are very low will look like a bad deal if 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 investor is loaning money to a government or a 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 rating of the bond 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 yields decrease.
That means that a bond held by an investor will lose face value if interest rates rise. That is, if the bond were sold on the secondary market, it would be sell 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 full-face value when it reaches maturity, regardless of secondary market fluctuations.
Special Considerations About Safety and Liquidity
CDs are ultimate safe haven investments given that 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, both come with a commitment to a length of time. You may not want to commit to a long-term CD when interest rates are low, or to 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. That is, they can be turned back into cash fairly quickly, but 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 a loss of value and the foregoing of future interest payments.
The wise investor keeps an emergency stash where it is available without penalty. That probably means a regular savings account.
- 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.
- Both are considered safe haven investments, with modest returns and low risk.