The answer is, that depends. In a volatile market, investors may look to certificates of deposit and bonds as safe havens. CDs and bonds entail lower levels of risk than investing in stocks while also producing interest income.
They’re not identical, however, and they can be affected differently by things like rising interest rates and changes in the market. Understanding how CDs and bonds compare can help you determine whether one or both of these investments belong in your portfolio.
Measuring CD and Bond Returns
CDs and bonds operate differently in generating returns. Both are affected by the current interest rate environment, albeit differently.
When the Federal Reserve institutes rate hikes, banks typically increase CD rates correspondingly. A higher rate translates to more interest earned. Conversely, when interest rates are low, the rates on CDs drop, meaning lower yields for investors.
Consider CD performance over the past decade. The national rate for non-jumbo, 12-month CDs with deposits of less than $100,000 was 1.29% in May 2009. This marked the beginning of a downward slide as the Federal Reserve instituted a policy of easing rates to bolster the economy after the 2008 economic collapse. After falling to 0.20% in June 2013, CD rates flatlined, but they began rising again in late 2017 after the Fed announced that it would begin increasing the federal funds rate.
At the end of May 2018, the national rate for 12-month non-jumbo CDs reached 0.38%. It’s important to note that these are national rates and don’t reflect CD rates offered by individual banks. It’s possible to find high-yield CDs from online banks with rates well above 2%.
In other words, rising interest rates are a good thing for CD investors.
That's not necessarily the case for bond investors. Bonds and interest rates typically have an inverse relationship. When rates are low, bond prices are high; when rates rise, bond prices fall. If you own bonds in a rising rate environment, the prices of those bonds will decline.
However, bonds aren’t all affected equally by rising rates. Bonds that have a longer maturity term tend to see more of an impact than those with a shorter term. A 10-year bond, for example, will be more sensitive to changes in interest rates than a 2-year bond. If your bond portfolio is primarily composed of long-term bonds, the returns from CDs could easily outpace bond yields.
Inflation is also a factor. When inflation rises steadily, the higher returns from CDs may have trouble keeping up. Rising consumer prices can also negatively impact the real rate of return from bonds, shrinking investors’ purchasing power. When higher inflation is combined with rising rates, bond investors can experience a double hit.
Safety vs. Liquidity
Aside from returns, the safety and liquidity of CDs versus bonds is another key consideration. All things being equal, CDs and bonds are both safer than stocks or mutual funds. But when interest rates rise, bonds may become more of a gamble if their yield potential is diminished.
In short, there’s a high probability of not getting back some or all of your investment in a bond when rates rise. CDs insured by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) are at the other end of the risk spectrum. Even if the bank issuing a CD goes bankrupt, the funds are insured by a government-chartered agency for up to $250,000 per depositor, per financial institution. Effectively, CDs have a government guarantee that the CD owner won’t lose money.
The advantage that bonds have over CDs is liquidity. While it’s possible to liquidate a CD, banks often charge a penalty for doing so ahead of the CD’s maturity date. If you’re charged a stiff penalty for withdrawing a CD early, that could erase any benefit associated with higher rates.
Turning a bond into cash is, in many cases, less expensive than cashing out a CD before it fully matures. Penalties for cashing in a CD early range from foregoing three months of interest, to potentially losing a small portion of principal. If you think you might have to cash in a CD early, you may be better off choosing a CD with a shorter maturity period, or putting your money in a high-yield savings account instead.
The Bottom Line
CDs and bonds can both be attractive to investors for different reasons but whether to invest in one over the other often hinges on what’s happening in the broader market. When interest rates rise, for instance, bonds may lose some of their luster, while CDs grow more appealing. On the other hand, if you’re investing in short-term bonds, they may offer greater liquidity than a CD, while still producing solid yields. Weighing the advantages and disadvantages of both against the backdrop of where the market is currently – and where it’s headed – can help you decide where to put your investment dollars.