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Banking 101: Bonds vs. CDs - Which Is a Better Investment?

Written by Anne Bouleanu | Published on 4/19/2019

Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.

If you’re building a robust and well-rounded investment portfolio, you should consider investing in both bonds and certificates of deposit (CDs). Both CDs and bonds share similar features and performance, however investors should understand the key differences between them.

With both bonds and CDs, you are the creditor, but the entities asking for your money are not the same. CDs are always offered by banks, credit unions and other depository institutions. Meanwhile, public and private companies, as well as governments — from nation states to municipalities — sell bonds to raise funds for nearly any reason. Time to maturity is also very different: Bonds have longer terms, while CDs have relatively shorter terms.

Grasping all of the similarities and differences between CDs and bonds should help you determine how much of each to hold in your portfolio.

In this article we will cover:

Bonds vs. CDs: Which should you choose?

Both bonds and CDs are fixed-income securities. Once you invest, you won’t necessarily have to do anything, like watch the stock market or worry about interest rates, until they hit their maturity date. When you purchase either bonds or CDs, you’ll know exactly how much money you stand to earn by the end of the investment term. This makes both instruments very low risk.

However, one difference between the two is that CDs generally offer easy access, charge no fees, and accept low minimum investments, while bonds are seldom free of fees. When buying bonds, you may have to pay some trading costs and other fees upfront.

The value of a given bond shifts as the market fluctuates. Whole swaths of the professional investing world are engaged in bond trading for big profits. However, if you hold a bond to maturity, you get the return you were promised at the time you invested.

Bonds are considered long-term investments and take 10 or more years to reach maturity, making them a strong and secure method for investing with a long time horizon. These investments are frequently used in individuals’ portfolios as a security measure to balance out higher risk investments, like stocks and IPOs.

If you want to receive the same interest payouts during the course of the investment term or opt for high-interest returns over a short period of time, CDs may be a good fit, as CDs offer maturity dates as short as a month or as long as five years (even longer-term CDs are also available), acting as a method to round out a portfolio that already has long-term investments.

Bonds vs. CDs: Return on investment

Understanding the return on investment from your assets is the very heart of investing. Bonds and CDs offer differing returns on investment. For the last 10 years, for example, U.S. Treasury bond rates have been lower overall than CDs rates.

Bond yields took a hit during and after the financial crisis, falling drastically from 3.5% in 2008 and bottoming out at just over 0.5% in 2013. These rates have since rebounded, but still remain lower than CDs.

As of Mar. 1, 2019, bond yields for a 5-year investment sit around 2.56%. Meanwhile, the strongest annual percentage yield (APY) rate for a 5-year CD, meanwhile, is 3.51%.

Bonds vs. CDs: Risk and reward

CDs are insured by the federal government, which is why these investments are considered low- to no-risk by financial advisors. They are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per investment.

CDs are so safe, in fact, that the federal government has never failed to pay out a CD investment since the founding of the FDIC in 1933.

U.S. Treasury bonds are not insured by the government in full. Rather, they are backed by the full faith and credit of the U.S. government, and for all practical purposes, that’s as good as being insured — the federal government has never failed to distribute returns or interest payments. Because U.S Treasury bonds are so safe, the government allows investors to include as many bonds to their portfolios as they like.

Private bonds are a different matter. Investors purchase bonds as investments in corporations, essentially acting as IOUs to raise money. If, however, a company goes bankrupt or defaults on the bonds, investors may not receive their interest payments or principals at its maturity date.

Bonds vs. CDs: Varieties

  • Corporate bonds: Debt securities sold by public and private corporations.
  • High-yield bonds: Bonds that offer higher interest rates and lower credit ratings, and carry a higher credit risk. Also called junk bonds.
  • Investment-grade bonds: Bonds that offer lower interest rates and higher credit ratings, and carry lower credit risk.
  • Municipal bonds: Bonds distributed by counties, cities, states and other government agencies. There are several types of municipal bonds:
    • Revenue bonds: These are funded by government projects such as tolls and transit systems.
    • General obligation bonds: These are backed by “full faith and credit” from the issuer and are unsecured by assets.
    • Conduit bonds: Government-issued municipal bonds distributed for third-party private bodies, like hospitals.
  • U.S. treasuries: These bonds are issued by the federal government through the Department of Treasury, made in full faith and credit of the U.S. government.
    • Treasury notes: Bonds that mature within 10 years.
    • Treasury bills: Short-term bonds that mature anywhere from a few days to one year.
    • Treasury bonds: Long-term investments that usually mature in 30 years. Interest payments are made to the investor twice a year.
    • Treasury Inflation-Protected Securities (TIPS): Notes and bonds that mature in measures of five, 10, and 30 years. These are investments whose principal changes based on fluctuations in the Consumer Price Index.
  • Short-term CDs: Certificates of deposit with short investment periods, often less than one year, carrying lower interest rate payouts than those with longer terms.
  • Long-term CDs: These have investment periods longer than one year, with higher interest rates than short-term CDs.
  • Variable-rate CDs: Rates on these CDs change according to market indices, which can boost your investments if you anticipate market rates will rise. However, these variable-rate investments are also subject to changes as markets fall.
  • Jumbo CDs: These require investments of $100,000 or more. Jumbos may offer higher interest rates than regular CDs.
  • Brokered CDs: Managed through a broker. Brokers offer industry knowledge, but you’ll pay for their services.
  • Step-Up CDs: These provide the opportunity to change your rate if market rates are on the rise.
  • CD ladders: A collection of CDs with varying term lengths. A ladder is a group of CDs, combining long- and short-term investments to allow investors some flexibility in their portfolios.
  • CDs in IRA accounts: You may keep CDs in an IRA account as part of your overall retirement strategy.

Bonds vs. CDs: Access to funds

Before you invest in bonds or CDs, understand the barriers you may face in accessing funds during the life of the investment. When you invest using bonds or CDs, you lock in your investment until the bond or CD reaches its maturity date. If you need to access these funds before they reach maturity, investors may face financial penalties.

When you break a CD before it reaches maturity, you may pay anywhere from three to 12 months in interest as a penalty, and often will have to sell the CD in its entirety.

Bonds, on the other hand, offer more flexible liquidity. For example, investors are able to sell Treasury notes in sums as low as $100. This provides the freedom to make small changes to an investment portfolio and to buy and sell more easily as the market fluctuates.

Bonds vs. CDs: Where to buy and invest

Bonds and CDs are a common investment vehicle and both are generally easy to locate and buy. Bonds are available through both private corporations and the U.S. government. You can buy government bonds directly through the U.S. Treasury, and may do so online by opening an account on the TreasuryDirect website. You can also buy government bonds through a broker, dealer or bank.

You can also buy private bonds through corporations, both public and privately held. These act in the same manner as government-issued bonds, and can be purchased through banks, bond traders and brokers. When investing in corporate bonds, be sure to research the company’s risk rating through investor services such as Fitch, Moody’s and Standard & Poor’s.

Investing in CDs is slightly different. Unlike bonds, they are only distributed privately, by entities like banks and credit unions. Search for an insured bank to make sure your CD will be backed by the FDIC up to the $250,000 limit, and compare and contrast banks’ current CD yield rates. Once you’ve found the financial institution of your choice, decide how long you want to keep your CD in place before its maturity date, and ask whether you’ll incur any penalties if you close out your CD before that maturity point.

Building a conservative investment strategy

Stocks and bonds are both strong vehicles to add to a conservative investment portfolio. Their low risk, as well as the ability to purchase multiple CDs and bonds, may give conservative investors peace of mind that their long term investments will remain safe.

But according to Ken Tumin, Founder & Editor of DepositAccounts, there are really no simple answers when it comes to deciding on a specific, conservative investment strategy. However, he recommended taking into account both risk and balance when deciding what share of your money to put into stocks, bonds and CDs.

“Factors to consider include your time horizon and appetite for risk,” said Tumin. “For corporate and municipal bonds and for CDs with deposits amount above the insured limits, there are credit risks. Also, all bonds and brokered CDs have interest rate risk.”

John Hetzel, a Certified Financial Planner at Beaird Harris, recommends including both bonds and CDs for conservative investors.

“We try to focus on years of spendable income in bonds and CDs,” Hetzel said. “However, we prefer to use bond funds so we can take on a little more credit risk since the diversification will help offset that risk,” adding “and we get a little extra yield for that trade-off.”

The bottom line: How to choose between bonds vs. CDs

Bonds and CDs are not mutually exclusive. Your portfolio can include both, and combining these vehicles can add security to both your short- and long-term investment strategy.

If you’re looking to add a short-term boost to your portfolio, you should consider short-term CDs that offer higher yield rates than bonds. You should also consider building a CD ladder containing CDs with term lengths in increments of, for example, 1-, 5- and 10-year maturity dates.

On the other hand, if your main priority is long-term security, government-issued bonds are a great choice, with issuance terms as long as 30 years. Bonds also give you the option of withdrawing funds without incurring penalties, whereas CDs offer higher interest rates but charge fees for ending the investment early.

There are pros and cons to both, but always keep in mind that these investment choices are personal, and selecting low-risk vehicles such as CDs and government bonds can help you round out your portfolio to achieve your conservative investment strategy.

  |     |   Comment #1
Building an individual bond portfolio can require a significant investment. It's OK for Treasury bonds, but challenging for corporate bonds. Corporate bonds have default risk, so one should diversify and own corporate bonds from multiple issuers.

Probably the easiest way for entry-level investors (and not-so-entry-level investors) to play in the bond market is to invest bond mutual funds, through a brokerage or a mutual fund account directly at the fund company such as Vanguard or Fidelity. You can find some with low expense ratios and good diversification, holding thousands of individual bonds in the fund.

Bond funds act somewhat different from holding bonds outright. If you hold a bond, the principal is guaranteed at maturity. Bond funds buy and sell bonds, and have a rolling maturity, so the value of the bond fund fluctuates. A few bond funds exist that have a defined maturity date, after which they liquidate and distribute the principal to the fund holders.

In terms of economic opportunity cost, there's not much difference between holding individual bonds or a bond fund. They both have interest rate risk.

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