Understanding the key differences between bonds and certificates of deposit (CDs) can help you make better investment decisions. CDs and bonds offer opportunities for portfolio diversification while providing relative stability. While CDs are considered a type of deposit account, bonds can be considered a type of loan. Both investment options appeal to risk-averse individuals by offering a relatively low level of risk. Investing in CDs and bonds can offer investors peace of mind by offering modest and relatively reliable returns.
What are CDs?
CDs are often seen as a financial tool used to save money. CDs are considered a type of savings account that offers higher interest rates than those offered by typical savings accounts. A CD offers higher interest rates in exchange for individuals voluntarily locking their funds for an agreed term. CD mandates last from three months to several years. The length of term indicates how long an individual will not be able to access their funds. At the end of the CD term, customers will be able to access their funds in addition to the interest provided.
Financial institutions such as banks and credit unions offer CDs. One of the main advantages of CDs is that they have a certain level of predictability while offering account holders higher interest rates than those offered by other more flexible savings accounts.
In terms of security, CDs remain a solid investment option. CDs created at banks insured by the Federal Deposit Insurance Corporation (FDIC) are insured. This feature helps improve trust between the public and financial institutions.
CDs appeal to the most risk averse by offering predictable returns and security. However, CD rates are generally low, even in times of inflation.
What are bonds?
Bonds are a type of loan made by governments and companies to raise funds. Bonds are designed to be repaid with interest to investors.
Government bonds are bonds offered to investors by national governments to raise funds. These bonds are often considered the safest and most predictable.
Lower state and local governments offer municipal or municipal bonds.
Companies provide corporate bonds to investors. Investors who hold a corporate bond to maturity typically receive their principal plus interest. However, corporate bond investors are often exposed to an increased level of uncertainty due to the possibility of defaults. A default occurs when a borrower fails to make the necessary payments and eventually defaults on the obligation.
Since bonds can strengthen a portfolio against risk, they can be considered a slower and less aggressive investment opportunity. Bonds take time to mature, at which time the principal of the bond is fully repaid to an investor. The time it takes for a bond to mature depends on the terms specified. For example, short-term bonds generally take about a year to pay off. In contrast, long-term bonds could take around a decade to mature.
Bonds are considered less volatile than stocks but still expose an investor to some level of risk. The issuer of a corporate bond may default, exposing an investor to financial loss. Remember that bonds remain inflation-sensitive, which means that increases in inflation can decrease the value of a bond.
Advantages of investing in CDs
CDs have several advantages such as flexible timelines, improved yields, increased predictability, and greater security. A CD has safeguards in place that can offer investors peace of mind.
Flexible deadlines: Investors can select a schedule that best suits their investment goals. For example, CD terms tend to range from a few months to over a decade. This flexible schedule helps investors achieve their financial goals and meet their liquidity needs. Shorter-term CDs offer more flexibility but pay lower interest rates.
Predictability: CDs offer fixed interest rates. A set or fixed interest rate indicates that the rate does not change throughout the life of a CD.
Security: For a risk-averse investor, CDs may have some appeal because of their security. CDs purchased from an FDIC-insured bank are eligible for protection. According to the FDIC, deposits adhering to rules and regulations are protected at FDIC-insured institutions for $250,000. Before investing, research specific financial institutions to understand the rules and regulations.
Improved returns: CDs with longer durations usually have higher rates. High interest rates are intended to induce potential investors to lock in their funds for an extended period.
Advantages of investing in bonds
Bonds help offset aggressive investing and diversify a portfolio. The advantages of bonds include predictability, stability and the ability to protect capital.
Predictability: Depending on the type, investments can often be unpredictable or volatile. Bonds are seen as a predictable alternative to investments such as stocks. Bonds generally pay interest every six months, and the amount of interest varies depending on the bond.
Stability: Bonds are considered stable because they are loans with clear terms. Bonds can reduce the level of risk an investor is exposed to as part of a more aggressive portfolio.
Safeguard capital: Bonds repay an investor their principal plus interest. Bonds help protect the initial capital investment by stipulating that an investor must be repaid on the terms specified. Although bonds help protect capital, borrowers can default.
Possible tax benefits: Bondholders enjoy certain tax advantages such as tax exemptions. For example, investors in US Treasuries benefit from state tax exemptions. US Treasury bonds are generally subject to federal taxes. Research the potential tax advantages associated with government-issued bonds to understand which option would likely be best for your financial situation.
Special considerations for bond and CD investing
Before investing in bonds and CDs, consider the risk of inflation, potentially low returns and reduced liquidity.
Inflation risk: Inflation can raise interest rates, which lowers the value of CDs.
Low yields: Bonds and CDs offer lower returns compared to other investment options such as stocks. However, stocks expose investors to a high level of risk. Although bonds and CDs offer lower yields, they tend to provide a level of stability unattainable for more aggressive investment options.
Decline in liquidity: Investors should understand that bonds are tied to a maturity date, which makes them relatively illiquid compared to cash. Avoid placing funds in a CD or bond that you need to keep easily accessible. Instead, create an emergency fund to quickly access cash when you need it. An emergency fund should generally cover a minimum of three months of expenses.
Time: For time-sensitive investors, CDs and long-term bonds may be unattractive. Long-term CDs typically take over a year to mature. In contrast, long-term bonds often take more than a decade to mature. Bonds and CDs are considered long-term investments based on duration.
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Benzinga offers useful information and reviews on CDs and Bonds. Before investing, consider speaking with a financial professional to understand what would be best for you.
Frequently Asked Questions
Are bonds better than CDs?
Bonds and CDs can prove beneficial depending on key considerations such as current and future interest rates. Both are often considered safer investments. Ultimately, the preference between bonds and CDs comes down to personal preference.
Are CDs the same as bonds?
Although CDs and bonds are often considered smart options for moderate to low growth, they are not the same. CDs and bonds react differently to interest rates and follow distinct structures. For example, CDs are classified as a type of deposit account while bonds are generally considered a loan. Overall, bonds and CDs should not be considered the same.