Sunday, 25 August 2019

Bonds vs. CDs: What’s the Difference and Which Should You Invest In?

Bonds vs. CDs: What’s the Difference and Which Should You Invest In?
09 Aug
5:38

Investing in bonds and certificates of deposit (CDs) can be great options for investors seeking low-risk options for a pretty decent return on their capital. Both of these investing instruments are safer than many other options, like buying stock or investing in ETFs. But when it comes to deciding between bonds and CDs, it’s important to keep key differences in mind. Read on for an in-depth, side-by-side comparison of bonds vs. CDs.

Bonds vs. CDs: What are CDs?

Banks and credit unions sell CDs to depositors, who use them as very low-risk investment vehicles or to save money for short- and medium-term goals. With a CD, you agree to deposit a set amount of money with an institution and earn a fixed annual percentage yield (APY) for a fixed amount of time — referred to as a term, lasting from three months to 10 years. Different institutions offer varying APYs for CDs, and interest compounds over the term of the CD.

Once the CD term is over, you get back your principal and the interest earned over the life of the CD. If you opt to withdraw your money early, you generally must pay a penalty. Like other deposit products, bank CDs are insured by the Federal Deposit Insurance Corp. (FDIC), while credit union CDs are insured by the National Credit Union Share Insurance Fund (NCUSIF).

Bonds vs. CDs: What are bonds?

Bonds are a form of investment security that function like an IOU. Borrowers issue bonds to investors to raise money. When you purchase bonds, you are lending money to the bond issuer. In return for your investment, the issuer agrees to pay you a set rate of interest on top of the principal when it matures, or when it becomes due.

For bonds that have a fixed rate of interest throughout their term, you receive semi-annual “coupon payments,” and the interest rate is called the coupon rate. Some bonds offer interest rates that adjust over time, typically every six months, following changes in market interest rates. These are called floating rate bonds, and they are based on an underlying index. In one very common floating rate bond pricing scheme, the rate is based on a U.S. treasury bond plus 1%. Then there are zero-coupon bonds, where there are no periodic payments over the term of the bond. When the bond reaches maturity, the issuer makes a single payment that is higher than the initial purchase price.

There are four core types of bonds, that come in two categories:

  • Corporate bonds: Private and public corporations sell bonds to raise capital for expansions or operating capital.
  • Government bonds: The U.S. government and foreign governments issue bonds to fund government operations and make payments against outstanding debt.
  • Agency bonds: Bonds are sometimes issued by government agencies or government-sponsored enterprises, like Freddie Mac and Fannie Mae.
  • Municipal bonds: States, cities and counties issue bonds to raise money to pay for public projects, like the construction of roads and schools.
  • High-yield and investment-grade bonds: Each of the four types of bonds listed above can be classified as either high yield or investment grade. All bonds are rated by rating agencies. Bonds with good ratings are referred to as investment-grade bonds, as they carry less risk — but lower interest rates. Conversely, high-yield bonds carry more risk and higher interest rates (they can also be referred to as junk bonds).

Like CDs, the length of a bond’s term is set when it is first sold. Maturities range from a few months to up to 100 years, but most range from one to 30 years. Unlike regular CDs, not all bonds reach maturity: Callable bonds let the issuer liquidate a bond before it reaches the end of its term, usually because interest rates have changed.

Bonds vs. CDs: The basic differences

CDs are traditionally offered by banks and credit unions. You can invest with as little as $50, and you can choose a term as short as six months or as long as ten years. You can’t access your money before the end of the term unless you’re willing to pay a hefty penalty.

Bonds are offered by national governments, U.S. state governments, towns and cities and private and public corporations. You tend to need at least $1,000 to invest, and your bond may not mature for as long as 30 years.

  CDs Bonds

Issuer

Bank or credit union Government, state or local government, private and public corporations

Average term

Six months to 10 years One year to 30 years

Early withdrawal penalty

Up to six months’ worth of interest No penalty, but you could be forced to sell them for less than face value if redeemed before they mature

Bonds vs. CDs: Interest

While interest rates should play a big role in your decision to invest in bonds or CDs, it’s important to understand how the rates are calculated and paid out.

CDs can have variable or fixed-interest rates. Fixed-rate CDs have the same interest rate for their whole term. Variable rate CDs can fluctuate along with market changes. If the current rate is low, it may make sense to opt for a variable rate CD. Doing so will allow you to take advantage of positive market changes.

In general, the longer the term of the CD, the higher rate of return you’ll earn. For example, a three-month CD may have an interest rate of just 2.20%, while a seven-year CD could have an interest rate as high as 3.45%.

To put that in perspective, let’s say you invested $1,000 in a CD with a seven-year term and an interest rate of 3.45%. By the end of your term, your CD would be worth $1,273.14; your compounded yield on the investment would be $273.14.

How interest is paid on a CD can vary from bank to bank. Before depositing your money into a CD, check if the bank compounds interest on a daily, weekly or monthly basis.

A bond’s interest rate is referred to as it’s “coupon.” For fixed-rate bonds, coupon is determined by the face value of the bond — referred to as its “par value.” The coupon is quoted as a percentage of par. So, a fixed-rate bond with a par value of $1,000 and an annual interest rate of 4.5% would have a coupon rate of 4.5%.

With floating-rate bonds, the coupon resets on a semi-annual basis as market rates change. The London Interbank Offer Rate (LIBOR) is one common benchmark for setting the coupon for floating-rate bonds. If a floating-rate bond pays a rate of LIBOR plus 1%, and on the semi-annual reset date LIBOR is 2.5%, the new coupon would be 3.5%.

The greatest difference between CDs and bonds is that while most investors who take out CDs hold them to maturity, bonds are widely traded on a secondary market. A given bond’s price fluctuates above or below face value — or par, as outlined above — on the secondary market as interest rates and other markets change. As investors buy and sell bonds, prices rise above or fall below par.

When the Federal Reserve raises interest rates, the interest rate on CDs often goes up, too. By contrast, bonds are often negatively affected when the Federal Reserve raises interest rates. When interest rates rise, bond prices fall.

Bonds vs. CDs: Risk level

Every investment comes with some amount of risk, but each investment type has its own level of risk. Which investment option makes the most sense for you is dependent on your risk tolerance.

While bonds can provide you with a consistent stream of income, there are some risks you should keep in mind. With a bond, you’re dependent on the issuer’s ability to make timely payments; there’s no guarantee that you’ll make money with your investment. If the issuer runs out of money, the company could default on your bond.

If you sell bonds before their maturity date, they may be worth less than their face value. And, the bond’s interest rate may not keep pace with inflation, making them a less valuable investment.

However, the biggest risk is that bonds’ liquidity is dependent on market conditions. If there isn’t demand for the bonds, you may not be able to sell them when you want.

By contrast, CDs are generally a more secure investing option. According to the SEC, CDs are one of the safest savings options available. If you buy a CD from an FDIC-insured bank, your CD is insured up to $250,000, protecting you against bank failure.

However, not all CDs are insured. CDs offered by stockbrokers or investment professionals may be securities and not covered by FDIC insurance. Before investing in a CD, make sure you understand if your CD is covered or not.

Bonds vs. CDs: Term length and liquidity

When it comes to deciding which investment vehicle is right for you, keep in mind the difference in typical term lengths and liquidity. Your financial goals and ability to access cash should influence your decision.

CDs generally have term lengths of six months to five years. Once your term ends, you can cash in your CD or roll over your account into a new CD. While CDs offer higher interest rates than general savings accounts, they’re less liquid. You can’t make extra deposits or withdrawals from your CD before your term ends. If you decide to take out money early, you’ll have to pay a penalty.

For CDs, the most common form of early withdrawal penalty is a certain number of days’ interest on the CD, cutting down on how much interest you’ll earn. As of 2019, the average early withdrawal penalty for a five-year CD was 255 days.

Bonds can have much longer terms than CDs. According to the Financial Industry Regulatory Authority (FINRA), most bond maturities range from one to 30 years.

With CDs, your investment will gain interest as long as you leave it alone for its full term. With bonds, you run the risk of losing money. When the federal interest rates rise, bond prices fall. With lower bond prices, it can be more difficult to sell them before their maturity date. You may even have to sell them for less than you paid for it just to get rid of them.

Bonds can be more liquid than CDs, but you may lose some of your investment to get access to your money quickly.

Where to buy CDs and bonds

If you’re planning on investing in CDs or bonds, it’s important to know where to go. Most banks and credit unions offer CDs. However, it’s a good idea to compare CD yield rates and terms from several different institutions before deciding to invest your money. Rates can vary widely from one bank to another; shopping around can help you earn more money in interest.

Bonds can be more complicated. There’s generally three core options for buying bonds:

  • Work with a broker: If you want to invest in individual bonds, you can work with a firm and broker who specializes in them. You can find a reputable broker using FINRA’s BrokerCheck.
  • Purchase bonds in an ETF: If you invest in an exchange-traded funds (ETF) through your retirement account or individual investment account, you can choose to invest in bond funds and instantly diversify your portfolio.
  • Invest through the government: You can buy U.S. treasury bonds directly from the government through Treasury Direct.

Bonds vs. CDs: The final word

Both bonds and CDs offer valuable benefits and can play an important role in your investment strategy. If you’re looking for short-term results, opting for a CD with a term of five years or less may make the most sense for you. If you’re looking for more long-term security, investing in bonds can give you a reliable source of regular income.

When it comes to bonds vs. CDs, each form has its own pros and cons. By understanding how bonds and CDs work, how interest is calculated and paid out and what risks and penalties are associated with them, you can make an informed investment decision.

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Kat Tretina

Kat Tretina |

Kat Tretina is a writer at MagnifyMoney. You can email Kat here

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