- Bonds and CDs (certificates of deposit) are both fixed-interest investments, popular with investors seeking a low-risk income stream.
- CDs are federally insured and tend to come with relatively short maturity dates. Bonds often have 10-to-30-year terms and may offer tax advantages.
- CDs could be a good fit for short-term investors who don't want to risk losing principal, while bonds may be better for long-term investors or those seeking tax-free income.
- Visit Insider's Investing Reference library for more stories.
If you're looking for investments that can provide a steady income stream, bonds and CDs are two strong choices. While both are likely to underperform riskier investments like dividend stocks or real estate in the long-term, they also generally offer more safety and stability.
Bonds and CDs have a lot in common. But there are times when one may be a better choice than the other.
It's important to know the differences so that you choose the fixed-income investment that best suits your needs. Here's a rundown of the key features of each, and how to opt for one over the other.
What is a bond?
A bond is a loan that investors make to large entities, like governments or companies. In return for borrowing your money, the bond issuer promises to pay a certain interest rate over a set period of time and to repay the principal when the bond reaches maturity.
Government bonds are considered very safe investments, especially those issued by the United States Treasury. The US federal government has never defaulted on a debt.
State and local governments also issue these debt securities, known as municipal bonds. Their riskiness varies, depending on the state or municipality's credit rating.
Corporate bonds can be riskier than government or municipal bonds, but may also offer more attractive interest rates. To research a bond's degree of risk, you can check its credit grade assigned by credit-rating agencies like Standard and Poor's, Moody's, and Fitch. Like academic grades, they're letters, ranging from A to F. Any bond that gets ranked BBB or above is considered "investment grade."
What is a CD?
A certificate of deposit (CD) is actually a type of savings account offered by banks. With a CD, you promise to keep your money in the account for a specific period of time (usually from a few months to five years).
In exchange, the bank promises to pay a fixed interest rate that is often higher than it offers on its traditional savings account. Many CDs make interest payments on a monthly basis, but some banks may choose a different schedule (such as quarterly or semi-annually).
Many CDs will charge an early withdrawal penalty (EWP) if you take out your money before the account's maturity date. However, some banks do offer no-penalty CD products. And keep in mind that some banks will allow customers to withdraw accrued interest from their CDs without triggering an EWP.
Bonds vs. CDs: Key differences
From a strategic standpoint, what main features differentiate bonds and CDs?
1. Bonds trade on markets, CDs don't. While investors can choose to hold their bonds until maturity, many can also be sold beforehand on the secondary market. As a general rule, bond prices have an inverse relationship with interest rates. So when interest rates go down, bond prices tend to go up (and vice versa).
2. CDs are insured, bonds are not. CDs come with FDIC insurance of up to $250,000 per account-holder. And credit unions, which offer their own version of CDs called "share certificates," also carry $250,000 of federal insurance via the National Credit Union Share Insurance Fund.
Municipal and corporate bonds don't come with this kind of federal insurance protection. So if you lend money to a company that later finds itself in financial straits, it may be unable to fulfill its debt obligations.
This means that some bonds are riskier investments than CDs. However, it should be noted that Treasury bonds are backed by the same federal government that funds the FDIC (Federal Deposit Insurance Corporation). For this reason, federal bonds and CDs carry virtually the same (very low) level of risk.
3. Bonds are often tax-advantaged, CDs are not. CD income is generally taxed as normal income. So, if you happen to be in the 24% tax bracket, you'd need to pay $24 in taxes for every $100 of CD interest payments you accrue.
However, bonds issued by the government often come with tax advantages. For example, Treasury bond investors are only required to pay federal taxes on their interest payments, but not state. The exemption from local taxes could provide significant savings for investors who live in high income-tax states.
Municipal bonds come with great tax-saving benefits too. Income from these bonds is completely exempt from federal taxes and may be excluded from state and local taxes as well (if you buy one from the state you reside and file in).
4. CDs typically have shorter maturity dates. Many bonds have long-term maturity dates of 10 years or more. For example, Treasury bonds mature in 20 to 30 years. Meanwhile, CDs usually mature within 5 years, with a few banks offering longer CDs of up to 10 years.
When to consider CDs
Although it isn't necessarily an either/or, CDs have benefits over bonds if:
You think that interest rates will soon go up
Compared to traditional savings accounts, CDs are not a great place to have your money stashed in an increasing interest-rate environment. Savings accounts can raise their rates at any time, while your CD rates won't change after account opening.
But CDs are actually a safer bet than bonds when interest rates are going up. Why? Because the yield for bonds trading on the secondary financial markets will decrease as interest rates rise. But since CDs aren't traded on markets, their yields aren't diminished by rising rates.
If you expect rates to rise, buying short-term CDs for the foreseeable future may be the way to go. In this way, you can lock in your current yield while also giving yourself the flexibility to open new (and, hopefully, higher-yield) CDs each time an account reaches maturity.
You don't want to risk losing any principal
With a CD, it's highly unlikely that you will lose any of your initial investment. Even if you have to pay an early withdrawal penalty (EWP), the fee is typically calculated as a portion of the interest that you would have accrued over a certain period of time. Depending on how long you've held the account, that forfeiture of interest may not cut into your principal at all.
Selling bonds before their maturity date, on the other hand, can be trickier. If the current interest rates being offered on bonds are higher than what yours pays, you'll need to sell yours at a discount in order to attract a buyer. If you want complete protection from this kind of volatility, opening a CD account will be your better option.
You have a short-term investment horizon
It's true that there are some short-term bonds that come with durations of one to four years. But if you expect to withdraw your money that quickly, a CD may be the simpler investment vehicle. Plus, with a CD, you won't have to worry about incurring any trade transaction costs.
When to consider bonds
Bonds might be a better play if:
You think that think interest rates will soon go down
In a decreasing interest rate environment, bond yields typically increase. So if you feel like rates are primed to fall, choosing bonds over CDs could be a smart choice.
However, it should be noted that in March 2020 the Federal Reserve sets its benchmark interest rate at 0% to 0.25% to provide economic relief during the COVID-19 pandemic.
As a result, interest rates across a variety of banking products have hit all-time lows. With this in mind, interest rates (in the short-term) are more likely to stagnate or move up than suffer any type of precipitous fall.
You prize liquidity
Unlike CDs, you're never locked in with bonds — you can sell at any time, should your goals or needs change. Depending on where prevailing interest rates are, you could even sell it at a premium, realizing a nice little capital gain.
You want to minimize the taxes you pay on your investment income
Due to their tax advantages, federal and municipal bonds will leave you with more money in your pocket than a CD offering the exact same interest rate.
The difference will be most pronounced for investors in high tax brackets. Be sure to calculate the after-tax returns of bonds and CDs when comparing your options.
You have a long-term investment horizon
With many bonds having maturity dates of 10 to 30 years, they can be a great "set it and forget it" option for long-term investors who want to protect themselves against stock market volatility.
For instance, a 30-year old investor may choose a 70/30 (70% stocks/30% bonds) asset allocation for their investment portfolio. While this investor could technically continue buying new CDs every 5 to 10 years to provide a similar cushion against market volatility, that would take a lot more work.
Plus, investing in bonds over CD is simpler if you're looking to keep all of your retirement funds in the same 401(k) or IRA account.
The financial takeaway
Whether you're looking to increase your savings yield or hedge against stock market volatility, both bonds and CDs can be valuable additions to a diversified portfolio. But each has its own advantages and disadvantages. To decide which is right for you, you'll need to consider your income needs, investment time horizon, and your opinion about the future direction of interest rates.
If you decide that bonds are a better fit for your situation, investing in a diversified bond mutual fund or ETF could be an easy way to start. And if you decide to go with a CD, make sure to shop around for the best rates available, as they can and do vary among banks.
Related Coverage in Investing:
What are junk bonds? A risky yet high-yield investment that can bring rewards if you're willing to take the chance
ETNs combine a bond's reliability with a stock's profitability. Here's how they work, and how to weigh the risks and rewards
If you've ever considered putting money in a CD, now is probably the right time to do it
The key differences between a money market account and a money market fund, and how they each serve different financial needs
REITs are a way to own real estate without becoming a landlord — here's how they work, how to invest, and the different kinds to invest in
Source: Read Full Article