CDs vs. Bonds

How Do CDs and Bonds Compare?

Bonds and certificates of deposit (CDs) both offer a relatively safe way to grow your savings over time. As fixed-income investments, they provide a stream of payments over a period of time in exchange for effectively loaning your money to the institution that issues the bond or CD.

When you purchase a CD, you deposit a certain amount of money at the issuing bank or credit union for the length of the CD’s term, usually between three months and five years. You receive interest based on how much you deposit and when your CD matures.

A bond is a financial product that represents a loan to an issuing institution such as the federal government, municipalities or corporations. The loan is paid back after a period of time, usually between two and 10 years. Until then, the person who purchased the bond receives fixed-rate interest payments, called coupons, based on the loan amount, which is known as the principal or the face value.

Understanding which of these products is best for your situation can have a big impact on your personal finance. Let’s break down the key features of CDs and bonds to determine which is right for you.

Issuers and Terms

A CD is issued by a bank or credit union. Until the CD reaches its maturity date, you cannot add to the balance or take money out without paying an early withdrawal penalty.

Bonds can be issued by corporations as well as government agencies and municipalities. The terms of a bond can vary widely depending on which organization is issuing it, from treasury bills with a one-year maturity term to corporate bonds that can have a maturity of up to 30 years.

Like a CD, you cannot continue adding to the balance of a bond once it’s purchased, but you can purchase more bonds in increments determined by the terms of the specific bond. If you want to take your money out of a bond before its maturity date, you can sell it on the secondary market.

Interest and Return Rates

Both CDs and bonds pay out interest at regular intervals. For CDs, the interest is usually paid monthly, and the rate of interest is higher the longer the CD’s term lasts. The top-yielding long-term CDs may offer interest rates that exceed that of low-interest bonds like Treasury bonds.

The interest payments on bonds are called coupons, and the coupon payment frequency of a bond can vary based on the type of bond. The rate of interest paid on a coupon also ranges depending on the risk level of the bond. Bonds from government agencies are more secure but offer modest rates of return. Corporate and municipal bonds can offer higher interest rates than CDs, but there’s a bit more risk involved in purchasing these.

Bonds and CDs respond differently to interest rate fluctuations. As interest rates go up, CD rates tend to rise as banks want to remain competitive to attract customers. However, rising interest rates usually cause bond prices to decrease. This is because, as new bonds come onto the market with better interest rates, existing bonds with lower interest rates become less appealing to other bond investors.

Penalties and Risks

Certificates of deposit are insured by the Federal Deposit Insurance Corporation (FDIC) at banks and by the National Credit Union Administration (NCUA) at credit unions. FDIC insurance covers CDs up to $250,000 per depositor, per bank. Because of this, CDs are considered one of the safest fixed-income investments.

The risk level of bonds depends on the type of bond you purchase. Bonds issued by government agencies like the U.S. Treasury or the Federal National Mortgage Association (Fannie Mae) are backed by the U.S. government, so they’re considered to be very low risk investments.

Other bonds issued by municipalities or corporations may carry more risk depending on the bond’s rating, which is determined by the issuer’s creditworthiness. Bonds also expose the purchaser to interest rate risk, which refers to how the bond’s value responds to fluctuations in interest rates.

Both CDs and bonds levy penalties for taking your money out early, and these penalties are usually expressed as the interest earned over a certain period of time. CD early withdrawal penalties range based on the length of the CD’s term. A bank might charge a penalty of three months of interest on an early withdrawal of a one-year CD, nine months of interest on a three-year CD and a year of interest on CDs of five years or more.

Bond withdrawal fees are known as early redemption penalties, and they also vary based on the length of the bond and the issuing institution. For example, the U.S. Treasury allows holders of Series I and EE savings bonds to redeem their bonds after 12 months, but if the bond is redeemed before it is five years old, the holder will lose the last three months of interest the bond earned.

Impact of Inflation

High rates of inflation can negatively impact the money held in CDs. If the rate of interest you earn on your CD is not enough to keep pace with inflation, your money is effectively losing value over time. One way to sidestep the consequences of inflation is CD laddering, which gives you the chance to reinvest short-term CDs into longer ones with potentially higher interest rates.

Certain types of bonds adjust interest rates based on the rate of inflation. The most common bond of this type is called a Series I Savings Bond or I bond. The interest rate on these bonds is made up of a fixed rate that’s the same for the entire life of the bond and a variable rate that’s adjusted twice a year to account for inflation. This flexibility makes I bonds attractive to investors who are worried about their savings losing value due to inflation.

When Is a CD Your Best Option?

CDs might be a better option for the most risk-averse investors. Because they’re backed by FDIC or NCUA insurance, you can feel confident that you won’t lose any of the money you put in a CD.

These products also offer a high level of customization, so they’re ideal for reaching short-term savings goals. You can choose CDs with a variety of term lengths or special types like add-on or no-penalty CDs to better suit your needs. CDs are great if you’re saving up for something like a down payment on a house or car because you can earn more interest than a typical savings account without locking your money away for too long or risking losing it.

When Is a Bond Your Best Option?

Investors who are more risk-tolerant and looking for greater returns might prefer to put their savings in bonds. Most bonds pay a steady income in the form of coupons, so they’re useful for those looking for a fixed income stream.

Bonds can also be used to diversify an investment portfolio containing other securities like stocks or mutual funds. The latter products tend to have a higher level of risk, so adding some bonds to your portfolio can help hedge your investments against drastic fluctuations in the overall equity market.