CDs vs. Bonds: Understanding Safe Investment Options

Essential Information About Bonds

Bonds, like CDs, are essentially a type of loan. The bondholder is loaning money to a government or corporation that issues the bond for a set period in return for a specific amount of interest.

Bonds are issued by governments and companies to raise money. Highly rated bonds are as safe from losses as the entities that back them. Unless the government collapses or the company goes bankrupt, the principal is safe and the agreed-upon interest will be paid. Also, if a company goes bankrupt, bondholders are repaid before stock owners.

Bonds are rated by several agencies, the best known of which are Moody’s and Standard & Poor’s. The bond rating is the agency’s evaluation of the creditworthiness of the issuer. Many investors won’t go below the top rating of AAA, while others will go with BAA (medium risk) and even lower if it could mean higher coupon payments. Lower-rated bonds pay more interest, but that comes with additional risk.

A crucial difference between CDs and bonds lies in how they react to increased interest rates. When interest rates rise, bond prices decrease. That means that a bond will lose market value if interest rates rise. That is, if you sold the bond on the secondary market, it would go for less because other bonds would be available that pay a higher rate of return.

Advantages and Disadvantages of Investing in Bonds

When compared with CDs, bonds offer a few advantages. One is that most bonds are more liquid than CDs. Except for some types of savings bonds, you're free to sell bonds to other investors, even if the bond hasn't yet matured. You'll also receive regular interest payments, giving you a bit more liquidity than a CD, which usually locks its interest earnings in the CD until it matures.

Another advantage of bonds is that they usually offer higher interest rates than CDs. However, the reason for that is the key drawbacks of bonds. CDs are insured by the FDIC but bonds have no such protection. It's possible for the bond issuer to default, which would cause you to lose your investment.

Your bonds may also lose value if interest rates rise. While you won't lose out if you hold the bond until maturity, if you need to sell the bond before it matures, you could sell at a loss if the bond was bought when market rates were lower.

Bonds can also be more complicated. Some bonds can have provisions that affect their risk and returns. Callable bonds, for example, can be repaid by the issuer before their maturity date. That can leave you with a bit more uncertainty to deal with.

Evaluating Safety and Liquidity in CDs and Bonds

CDs are the ultimate safe-haven investments because the money is insured up to $250,000. U.S. government bonds are also extremely safe. High-quality, highly rated corporate bonds are effectively safe from all but catastrophe.

However, remember that both come with a commitment to a length of time. You may not want to buy a long-term CD when interest rates are low or a long-term bond when interest rates are high. Assuming that the historical trend reverses, as it always does sooner or later, you may be locking yourself into a reduced rate of return. Below are rates for popular bonds and CDs since 2000:

Both CDs and bonds are relatively liquid investments, meaning that they can be converted back into cash fairly quickly. However, cashing them in before their redemption date can be costly. In the case of CDs, the bank may impose a penalty that eliminates most or all the promised earnings since there is no legal maximum for the fee. In the case of bonds, selling early at the wrong time risks the loss of value and the forgoing of future interest payments.

Prudent investors keep an emergency fund where money is available without penalty. That probably means a regular savings account.

The Bottom Line

While both CDs and bonds are considered to be very safe investments, that safety ultimately depends on their issuers' creditworthiness and financial health. Typically, they're highly liquid securities and may be a good fit for investors based on their financial needs and goals, risk profile, and investment time horizon. Their returns are modest relative to other investments, but their investment safety and low risk may be just what you're looking for to diversify your holdings.

CDs are available through banks and brokerage firms, while U.S. savings bonds and other Treasury securities can be accessed through brokerage firms and directly through the TreasuryDirect platform.