CDs vs. bonds: how they compare and which is right for you
Bonds and CDs are both low-risk investments but serve different savings goals
Bonds and certificates of deposit (CDs) are both low-risk investment options that can help you make money. Both can be extremely attractive options when the market is volatile, which can help bring you financial peace of mind.
The two are structured in very different ways, but both can help you accomplish the same savings goal.
Key insights
- Bonds are debt securities that are issued by government bodies or companies. Most trade on the open market and pay a yield that can fluctuate.
- CDs are a type of savings account that is insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA). They offer locked-in rates that are generally higher than traditional savings accounts.
- Yields between the two are quite similar, so which one you pick should depend on your personal preference.
What are bonds?
Bonds are a type of debt security through which investors loan money to a government or corporation in exchange for a set interest rate over a fixed period of time. When the bond matures, the issuer pays back the principal plus interest in a guaranteed return.
Buying bonds is different from buying stocks, as stocks represent an ownership stake in a company. Even though stocks have the potential to generate higher returns, they are also riskier, as stock prices can fluctuate wildly and can result in a full loss of principal if the company goes bankrupt.
You can buy bonds by themselves or as part of a bond fund. If you want to buy Treasury bonds, you can purchase them directly via TreasuryDirect.gov or from your broker.
Pros and cons of bonds
Like any investment, bonds come with pros and cons that depend on your investing goals, risk tolerance and the current economy.
Pros
- Liquidity: Most bonds are traded on the open market, giving you the ability to buy and sell them at your own discretion.
- Reduced volatility: Compared with other instruments trading on the open market, bonds are far less volatile. This adds a level of comfort that other instruments do not.
- Safety: Bonds issued by the federal government or different municipalities are quite safe. Treasury bonds are especially safe, as they are backed by the full faith and credit of the U.S. government.
Cons
- Risk of loss: While treasury and municipal bonds are safe, corporate bonds can be quite risky. The safety of the bond depends on the financial health of the company and its ability to make payments.
- Relationship with interest rates: Bond yields are reliant on interest rates. In an environment in which interest rates are rising, bond yields also increase. It’s important to be aware of the current trend in interest rates.
- Opportunity risk: Compared with other options that trade on the open market, bonds have relatively low returns.
What are CDs?
CDs are a type of savings account offered by most banks and credit unions — at credit unions, they are called “share certificates” — with a set term and a fixed interest rate.
They are similar to bonds in that they are generally lower-risk than stocks, since the interest rate and principal are also guaranteed. However, they are more liquid than bonds.
You buy CDs by committing a certain amount of money for a fixed period of time, usually ranging from three months to five years. During this time, the money is held by the bank, and you earn a fixed interest rate on the money deposited. When the term ends, you can either withdraw the money or reinvest it in a new CD.
CDs are popular because they are a low-risk investment with the potential to earn higher returns than other types of savings accounts.
» MORE: What to do when a CD matures
Pros and cons of CDs
Just as with bonds, CDs come with pros and cons that will dictate whether they’re the right option for your financial situation.
Pros
- Higher rate of return: Compared with other accounts offered by banks and credit unions, CDs offer higher returns.
- Peace of mind: As long as your bank is insured by the FDIC, or your credit is insured by the NCUA, you are protected from the loss of your principal.
- Options: There are plenty of CDs to choose from, so you can pick the option that works best for you.
Cons
- Money is locked in: Most CDs require you to keep the full balance of your investment in the account for the duration of your chosen term.
- Penalties: In the event you choose to withdraw your money early, you may be charged fees.
- Opportunity cost: If you choose to invest in a CD with a relatively long time horizon (greater than two years), you sacrifice the opportunity to invest in other potentially higher-yielding investments.
The differences between bonds and CDs
While bonds and CDs are similar, there are several key differences worth noting as you decide which investment option is right for you.
Issuers
Bonds are debt instruments that are issued by governments and corporations to raise money for various purposes. CDs, on the other hand, are a type of savings account offered by banks and other financial institutions.
Interest payments
Bonds are typically issued for a fixed period of time and pay interest periodically. CDs are also issued for a fixed term, but instead of paying interest periodically, they pay out the total of a fixed rate of interest when the CD matures.
Bond investors can benefit from the periodic interest payments, while CD investors benefit from the fixed rate of return.
Buying/selling
Bonds trade on the open market, meaning you have the ability to buy and sell them at your own discretion. CDs, however, are only offered by banks and credit unions, and will generally lock you in for the duration of your term.
Risk
CDs are generally considered a safe investment option, as they are FDIC- or NCUA-insured. Bonds may be subject to greater risk, depending on the issuer, although government bonds are considered even safer than CDs.
» MORE: Is a CD investment safe?
Tax implications
Government-issued bonds can be tax advantaged, in that many will not require you to pay state taxes. However, corporate bonds and CDs are taxed at your marginal tax bracket.
Bonds vs. CDs: Which should you choose?
The decision of which instrument to choose is personal to you and has no right or wrong answer. CDs and bonds backed by a government body are very safe and even have comparable returns. Corporate bonds are riskier but offer potentially higher yields.
In the end, the choice comes down to slight differences between the two. Are you willing to give up the liquidity offered by bonds in exchange for the locked-in yield of a CD? Would you be willing to risk penalties or fees for accessing your CD early when most bonds can be easily sold?
Only after assessing your own risk tolerance and goals can you determine which is the right option for you.
FAQ
How safe are bonds?
Treasury bonds are backed by the full faith of the U.S. government, so they are as safe as it gets. Municipal bonds are backed by the issuing locale (state or city), so they are also very safe.
Corporate bonds are only as safe as the company issuing them is, so be sure to check the creditworthiness of a company by using a rating site such as S&P Global or Moody’s.
Do you pay tax on bonds?
Your tax burden will vary depending on the type of bond. Federal bonds carry no state tax burden, while municipal bonds carry no federal tax burden and may also be exempt from state and local taxes. Corporate bonds are taxed at your marginal tax bracket.
What are the types of bonds?
The different types of bonds include corporate (issued by an individual company), municipal (issued by a state or local government) and federal (issued by the U.S. government).
Bottom line
If you’re looking for a low-risk investment option, both bonds and CDs are good options. The question of which is best is personal and can only be answered by you.
Before choosing an investment, ensure that you have an emergency fund in place, and do not count these funds as being available for investment. Then, analyze your own risk tolerance and goals to see which of the two is best for you. Once you’ve decided, be sure to shop around to see where you can get the best rates.
