Cash News
Certificates of deposit (CDs) and bonds are relatively safe personal finance tools you can utilize to grow your money over time. But while CDs and bonds are both low-risk investments, the two function very differently — understanding their differences can help you determine which option is better for you.
If you have cash to invest and aren’t sure whether to put it toward CDs vs. bonds, here’s what you need to know.
What is a CD, and how do CDs work?
A CD is a type of savings account at a bank or credit union that offers a fixed interest rate on your balance in exchange for leaving your money in the account for a specified period of time. CDs tend to have higher rates of return than traditional savings accounts. Depending on the financial institution, CD terms can range from one month (short-term CDs) to 10 years (long-term CDs). Banks an credit unions often have a minimum deposit you must meet before you can open a CD account.
In most cases, you can’t add additional funds to your CD after your initial deposit or withdraw any funds from the CD until it reaches its maturity date. If you do, you’ll be charged an early withdrawal penalty. If you think you’ll need your cash sooner than later, avoid CDs that require a long-term investment and opt for one with a term of several months to one year.
After a CD matures, it’ll typically renew automatically for the same period. However, you’ll usually get a window of seven to 14 days to withdraw your funds or add more money to your balance.
What is a bond, and how do bonds work?
A bond is a type of investment in which you, as the investor, loan money to the bond’s issuer, which may be a company or a government agency. In exchange, you’ll receive a fixed interest rate and recurring payments of that earned interest — typically semi-annually — until the bond matures.
For example, if a bond has a $1,000 face value and a 6% interest rate, you’ll receive $30 in interest payments every six months.
Depending on the type of bond, the maturity date can be anywhere from a few weeks to 30 years in the future. Throughout the bond’s term, its value may fluctuate according to market interest rates — as interest rates go up, for instance, bond values go down. Once the bond matures, however, you’ll receive the face value.
Although it’s possible for investors to buy individual bonds, usually in $1,000 increments, it’s more common to buy them through mutual funds and exchange-traded funds, or ETFs.
Bonds or CDs: How to compare
As you think about where to put your money, you may be wondering, is a CD a good investment? What are the risks associated with bonds? Here’s what you should keep in mind.
Liquidity and terms
CD terms can range anywhere from one month to 10 years, and in most cases, you can’t access your money without paying a penalty until your CD matures. Some financial institutions offer penalty-free CDs, but they typically offer lower interest rates than standard CDs.
Depending on the type of bond you buy, terms can range from a few weeks to 30 years. However, you’re not stuck with the investment for the full term; you can sell your bond at its current value at any point.
Also, if you’re buying bonds through mutual funds or ETFs, you can sell your shares at any time.
Issuers and protection
The Federal Deposit Insurance Corp., known as the FDIC, and the National Credit Union Administration, or NCUA, offer you financial protection in the event that your bank or credit union fails. Because banks and credit unions offer CDs, your funds are typically NCUA- or FDIC-insured for up to $250,000 per depositor, per insured bank, for each account category.
On the other hand, bonds are issued by corporations and U.S. government agencies. Bonds purchased from government agencies tend to be safe, and bonds purchased through a brokerage firm may be insured for up to $500,000 by the Securities Investor Protection Corp. if the broker fails.
However, if you purchase a bond from a corporation and the company goes bankrupt, you risk losing your investment.
Returns
Returns for CDs and bonds can vary significantly, and in most cases, bonds offer higher returns, albeit with more risk involved.
The best CD rates will vary based on a number of factors, including the term length, the financial institution, and the overall interest rate environment. Many traditional bank or credit union CDs offer very low interest rates — typically expressed as an annual percentage yield, or APY. However, you may find online banks and financial institutions offering high-yield CD rates to compete for deposits. The difference may be huge: The corner bank might offer 1% even as an online competitor pays 4% or better.
Bond returns also can vary significantly depending on the type of bond and the risks associated with it. For example, bonds issued by the US Treasury tend to be the safest, but they also offer the lowest returns.
In contrast, corporate bonds can offer higher returns — particularly if the company has a less-than-stellar credit rating — but they also carry the highest risk of default.
Penalties
Unless you opt for a penalty-free CD, you’ll be assessed a fee for accessing your funds before your account matures. A common penalty may be 90, 180, or 270 days’ worth of simple interest.
If you sell a bond before it matures, you’ll miss out on future interest payments and the final par-value payment, but there are no penalties.
Risks
CDs are considered a risk-free place to put your money because, barring an early withdrawal penalty, your principal balance won’t go down. And as long as you don’t have more than the maximum insurance amount set by the FDIC or NCUSIF, your funds are safe even if your financial institution fails.
That said, CD rates are typically lower than the prevailing inflation rate, so your money can lose spending power over time.
While bonds tend to be less risky than stocks and other types of investments, they still carry different types of risk, including:
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Interest rate risk: If interest rates go up, the price of your bond will fall, which can result in a loss if you sell before the bond’s term is up.
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Credit risk: When buying corporate bonds, review the company’s credit rating. While some bonds may offer higher interest rates, the issuer may be at risk of defaulting on its payments, leaving you at a loss.
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Liquidity risk: While you can sell a bond at any time, there may not always be a buyer available. And if interest rates go up significantly, you may be hesitant to sell the bond at a deep discount.
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Inflation risk: Depending on the type of bond, you may not get a high enough return to outpace inflation. This is particularly true for short-term Treasury bills.
When is a CD the best choice?
Because CDs and bonds are fundamentally different, it may be easy to know which one is the right fit for you. If you’re unsure, however, here are some scenarios where it makes sense to opt for a CD:
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You won’t need access to your money until the CD matures
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You’re concerned about interest rates going down and want to lock in a high rate
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You don’t want to risk your principal balance
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You don’t want to spend time researching bonds to find the right fit
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You want to avoid the temptation to spend your savings
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You have a large purchase coming up at a specific time
When is a bond the best choice?
You may consider buying bonds instead of putting money in a CD if any of the following is true:
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You want to diversify your investment portfolio with safer investments
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You want to receive steady income payments
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You aren’t concerned about the risks associated with bonds
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You expect interest rates to go down in the near future