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. 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.
Risks of Bonds
Before you invest in bonds, it’s important to understand the risks.
Default risk: The company or municipality issuing the bond may not be able to repay it. Looking at a bond issuer’s credit rating can help you reduce the chances of default.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 risk: 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.Liqduidity risk: 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. 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.
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.
CD Yields Are Virtually Guaranteed
Since CDs are issued with set interest rates by banks, there is nearly a guarantee that you’ll receive the interest payments—especially if the issuer is a large financial institution. In addition, the longer the term of the CD, the higher the rate the bank will pay, so it will yield more. If a bond has a fixed rate, then it will pay that rate for its lifetime. However, a floating-rate bond yield will change with the interest rate over time, so it can offer high yields in times when rates are rising and lower yields when rates are dropping. 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.
