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Both certificates of deposit (CDs) and bonds typically pay higher interest rates than a traditional savings account. They're also relatively low-risk investments, meaning you don't have to worry as much about capital loss when purchasing them as you would with equities.
However, there are some key differences you should be aware of when deciding which type of asset you should purchase. This article takes an in-depth look at bonds vs. CDs to help you find the right fit for your goals.
What are bonds?
Bonds are loans between you and the issuer, which can be the federal government, large corporations or individual government agencies, such as the IRS. Issuers promise to pay an annual interest rate on the value of the bond.
For example, if you paid $10,000 for a bond, you could earn 4% interest per year, which is the average long-term rate for AAA corporate bonds. That may be less than what you could make from investing in stocks, but bonds carry limited downsides, whereas equities can deplete your capital if the share price goes down.
How do bonds work?
When the government or a private company wants to raise funds, they can issue bonds. These are essentially loan offerings stating that if you give the organization a certain amount of cash, they'll return it in a specified number of years while also paying a fixed interest rate annually.
Bonds are a safer type of investment because they typically involve giving a loan to a reputable company or the U.S. government, both of which are unlikely to default.
However, if you want to purchase bonds, you should research before doing so. Factors like the rate of inflation when the savings bonds mature can influence whether they're a wise investment in your current situation.
For example, if you buy bonds and the interest rate later goes up, you won't lose your capital investment. However, if you want to cash out of the bonds early on the secondary market, you would likely have to accept less than what you paid for them. This is because newer bonds with higher interest rates would already be available on the market.
Types of bonds
Bond investors have a variety of bond types to choose from, but you can find a few standard options on the market.
U.S Treasury bonds
U.S. Treasury Bonds are considered the lowest-risk bond investment. This is because they are issued on behalf of the U.S. government and are backed by the so-called full faith and credit of the federal government. Government bond options include Notes (can mature in 10 years or less), Treasury Bills (can mature in as little as a few days or as long as 52 weeks), and Series I Bonds (typically mature in 30 years). Buying I bonds is a fairly easy process and can provide a stable monetary source in the future.
Corporate bonds are a type of bond issued by private companies. Third-party analysts, such as Moody's, Fitch and Standard & Poor’s (S&P), typically grade these. Corporate bonds with higher grades are considered safer but may pay lower interest rates.
Cities, counties and state-based government bodies also offer municipal bonds. They typically pay lower yields than corporate bonds but are generally more secure.
High-yield bonds are issued by companies and organizations that may have a higher risk of default than other issuers. You can earn a higher rate of return on these bonds but will have to accept a higher risk of possibly losing your investment.
How to invest in bonds
There are several ways to invest in bonds. One option is to purchase them directly from the U.S. government, which you can do by visiting the Treasury Department's website.
Alternatively, if you want to purchase municipal or corporate bonds, you can go through a bond broker to do so. Popular retail investing platforms like eTrade and TD Ameritrade typically offer this service in addition to equities trading.
What is a certificate of deposit (CD)?
Bonds and CDs are both low-risk investment options and may sometimes pay similar interest rates, but CDs are a type of savings account offered by banks.
With a CD, you agree to deposit a specific amount into an account for a predetermined period. In exchange, the bank pays you a higher interest rate than a traditional savings account.
How do CDs work?
CDs typically have a minimum deposit requirement and a term length that define the amount of money you need to put into the account and how long the cash needs to remain in the account to qualify.
One thing to note about CDs: They typically carry hefty withdrawal penalties. If you try to withdraw your funds before the term expires, you may lose some or all of the interest you've already earned and potentially some of your deposit.
Types of CDs
Certificate of deposit rates change based on the type of CD you choose. There are a variety of CDs that operate slightly differently from one another.
Traditional CDs are what this article has described so far. They offer a higher interest rate than a standard savings account but ask you to keep a certain amount of funds in the account for a predetermined time.
Some companies offer high-yield CDs to stand out from the competition. These pay higher interest rates but tend to have larger minimum deposit requirements and longer term lengths. Still, they can be a solid option if you're okay with locking up a larger amount of capital for a long-term safe investment.
Bump-up CDs are like traditional CD accounts but allow you to take advantage of increasing interest rates. For example, if you enter into a CD agreement and the federal government increases rates, the bank may now offer the same CD you chose with higher rates. You can benefit from that rate increase with a bump-up CD, whereas that wouldn't be possible with a traditional CD.
Nonetheless, most companies offering this type of CD tend to limit how often you can "bump up" your rate. You may only get to do so once per term.
How to invest in a CD
Investing in CDs can be as simple as researching the best CD rates online and choosing a provider. There are rarely qualifying criteria outside of a willingness to deposit at least the minimum amount for the established term length.
However, if you want to make CDs an ongoing part of your investment strategy, you should remember that interest rates will fluctuate from year to year. That's why people use various techniques to invest in CDs, such as the following:
- CD ladder: A strategy that divides your CD investment into different CD accounts with staggered term lengths. As each CD term ends, you can reinvest the funds into a new CD with the latest interest rates.
- CD barbell: This strategy involves splitting your CD funds into short and long-term CD accounts. You can hold off on putting your total CD allocation into long-term accounts until interest rates rise while still benefiting from the current rates.
- CD bullet: This strategy focuses on making multiple CD investments that all end simultaneously. It can be effective if you plan on making a large purchase at a certain date, such as a home, and want to earn more than a traditional savings account would offer.
What is the difference between bonds and CDs?
Though both CDs and bonds operate as ways to grow your savings, they work quite differently from one another. They vary in terms of requirements, return on investment, liquidity and risk assessment.
Minimum investment requirements
The offerer sets the minimum investment requirements for CDs and bonds, which can vary. Some companies, such as Capital One and Synchrony, offer CDs with no minimum investment requirements.
Bonds are typically very affordable. I Bonds are available for as little as $25, so there is likely an option that fits your plan regardless of your financial status.
Rate of return
Both bonds and CDs can offer higher rates of return in different financial environments. CD rates rise and fall as the Federal Reserve (the Fed) sets its funds rates. In other words, CDs pay more when the Fed raises its interest rates.
The rate of return on a bond will also fluctuate based on the government's interest rate changes. However, the face value of the bond — the amount you paid for it — will decrease if interest rates go up after your purchase. If you wanted to sell the bond on the secondary market, you would likely have to accept less than you paid for it.
The bottom line is that CDs and bonds can offer better returns at different times. Research current rates to determine which makes more sense for you.
Both bonds and CDs are designed to be long-term investments. While there are ways to reclaim your initial investment early if you need to do so, it may come with penalties. You would be subject to fees if you withdraw your money from a CD early. These penalties could cancel your interest earnings and eat into your initial investment.
If you wanted to cash out of a bond early, you could sell it on the secondary market or simply cash out through the bank you bought it from. Neither option will take away interest that you've already earned, but you won't get the full amount if you cash out early.
Investments in both CDs and bonds carry inflation risks. If the interest rate you receive from the asset is lower than the inflation rate, you're effectively losing money on your upfront investment.
However, some bonds and CDs deal with this problem in creative ways. For example, bump-up CDs allow you to increase your interest rate to beat inflation. Series I Bonds also incorporate a flexible interest rate element that adapts your earnings to account for inflation.
When to buy bonds
Bonds may be suitable for investors who are concerned about liquidity since you can often cash them out without penalties. However, it's best to hold a bond until it matures to earn its full amount of interest.
Some individuals buy bonds for their children and time the bond's maturation date with a time when their offspring are expected to make a big purchase. For example, the average first-time homebuyer is 36. If bonds purchased for a child matures when they're about this age, they could have a nice cash inflow just when they need it most.
You may also want to look at your future when deciding whether to purchase a bond for yourself. Timing a bond with your anticipated retirement date can ensure you have extra cash available after you’re no longer receiving work income.
When to open a CD
The best time to open a CD is when interest rates are high. This is because CD rates are based on the federal funds rate, which is set by the Federal Reserve. Since CD rates are typically fixed, your rate will stay the same regardless of how the Federal Reserve changes its rates after you open the account.
When do savings bonds mature?
Savings Bonds are another name for bonds issued by the Treasury Department. They mature in either 20 or 30 years, depending on the type you bought. If you want to cash out of a savings bond early, you can typically do so through most banks.
What happens when a CD matures?
When a CD matures, you typically get a certain number of business days to withdraw your funds from the account penalty-free. If you don't withdraw your funds, it may automatically roll over into a new CD agreement. Every bank has a different policy, so check with yours before deciding what to do with your money.
Are CDs or bonds better for investing?
Many people invest in bonds and CDs to diversify their portfolios. You may wish to do the same. Alternatively, you can evaluate bonds versus CDs based on current interest rates.
CDs may be the better option when rates are higher. But when interest rates are lower, bonds could make more sense. You can check the federal funding rate online.
CDs are also shorter-term investments than bonds. Ultimately, your overall timeline is the greatest factor in determining the better investment option.
Summary of Money's Bonds vs. CDs
Bonds and CDs both pay investors more than traditional savings accounts. They are a relatively low-risk way to earn interest on your cash. While they may offer less return than riskier options such as the stock market, they can make great investments for the future as you steadily build on your initial investment.