When it comes to saving for the future, there are many options to choose from. One of the most common is the certificate of deposit or CD. But what is a CD? How does it compare to a bond? And what are the differences between certificates of deposit vs bonds?
In this insightful article, we will discuss the differences between CDs and bonds, as well as their advantages and disadvantages. We will help you decide which one is better for you.
What is a certificate of deposit?
A certificate of deposit (CD) is a savings account with a higher interest rate and a set term. For example, you could open a three-year CD that pays you 3.25% APY (annual percentage yield) more than a standard savings account.
This may not seem like much but it can be the difference between beating inflation and losing purchasing power. The trade-off is that you have to leave your money untouched for the duration of the CD’s term. If you need to access your cash before the CD matures, you’ll likely have to pay a penalty.
That's why it's best to only use CDs for money that you won’t need access to for at least a few years. CDs are one of the safest investments since they’re insured by the FDIC for up to $250,000 per depositor.
By having this insurance, you can sleep well knowing that your money is safe even if the bank were to fail.
What is a bond?
Bonds are debt securities that governments or corporations issue to raise money. When you buy a bond, you’re essentially loaning money to the issuer with the expectation that they will pay you back over a set period with interest. The interest will be your ROI (return on investment).
What are the differences between CDs and bonds?
The biggest difference between bonds and CDs is that bonds are not FDIC insured. This is problematic for bondholders because if the issuer defaults on their debt, the bondholder could lose all of their investment. This is a much riskier proposition than investing in a CD.
Another big difference is that bonds typically have longer terms than CDs. For example, you could buy a ten-year corporate bond while the longest term CD is usually only five years.
However, bonds can be traded while CDs cannot. This means that you can sell your bonds before they mature without penalty, unlike with CDs.
Finally, the interest payments on bonds are not guaranteed like they are for CDs. This lack of guarantee needs to be accounted for if you plan on investing in this asset class. With a CD, you know exactly how much interest you will earn over the life of the deposit. With a bond, however, the issuer may elect to not make interest payments if they’re in financial distress.
Advantages of CDs
The most common reason why people invest in CDs is for the guaranteed interest payments. By knowing exactly how much money with certificates of deposits, you can better budget for the future.
It also gives depositors peace of mind that their investment is safe and calculable despite market conditions. Those with low-risk tolerance are also usually drawn to CDs since they are FDIC insured. Insurance is important. Even if it's a low-risk savings vehicle.
Disadvantages of CDs
Investors that are seeking high returns would be at a disadvantage investing in these types of assets. CDs have low returns when compared to other types of investments like stocks and real estate.
Liquidity of cash is also a problem with this type of savings option because you're not able to access your money without paying a penalty. If an emergency fund is what you're after, a CD is not the best option.
Remember that anything can happen and you might not want to position yourself where you have to pay a fee just to access your own cash. The other option might be to sell other assets at a loss or visit a predatory lender. Clearly, these are not ideal scenarios. A lack of liquidity is a major disadvantage.
Advantages of bonds
The 60/40 portfolio is a common investment strategy that allocates 60% of assets to stocks and 40% to bonds. The reason for this is that bonds act as a buffer during stock market corrections. This is because bonds and stocks often move in opposite directions.
So, this asset's main advantage is that it helps diversify an overall portfolio into an entirely uncorrelated asset class. You can diversify into different stock sectors but at the end of the day, they are all still stocks.
Bonds provide stability and peace of mind during market volatility which is why many investors choose to allocate a portion of their portfolio to this asset class.
Disadvantages of bonds
While a bond allocation can be helpful for investors, it’s important to remember that bonds are not without risk. The biggest risk is interest rate risk. This is because when interest rates rise, the value of bonds falls.
The reason why this happens is that when rates go up, new bonds are issued at a higher rate which makes existing bonds less attractive to investors. Another reason why bonds can be risky is that they are not FDIC insured.
We briefly mentioned this earlier but let's explore why this insurance is important. Imagine if you were to drive a car without insurance and it crashes due to the weather. The damages would have to be paid entirely out of pocket which would likely be very expensive.
The same goes for investing in bonds. Bonds are an investment vehicle that is also subject to economic weather cycles. Recessions and even depressions tend to be cyclical and if you invest for long enough, you are bound to experience one.
So, if you've invested in bonds and there's an economic downturn, the issuer may default on their debt.
In fact, countries such as Greece and Argentina have defaulted on their debt in recent years. This would mean that bondholders would not receive the interest payments or the return of principal.
Finally, the disadvantage of bonds is that they have low returns when compared to other assets. As mentioned earlier, if your rate of return does not keep pace with inflation, you are losing money in real terms.
Certificates of Deposit vs Bonds: Which one is right for you?
The answer to this question depends entirely on your investment goals and risk tolerance. It also depends on the individual CD and bond itself. For example, if you are investing in bonds in a country that has a history of defaulting on its debt, you are taking on more risk. The same goes for CDs.
If you are investing in a CD that has a high minimum deposit, you are also taking on more risk. In general, CDs are going to be less risky than bonds but they also have a lower potential return.
You can save money on them but it won't save you from inflation. The bottom line is that you need to figure out what your investment goals are and how much risk you are interested in taking.
Bonds are more liquid and can give you access to capital for more growth-oriented opportunities. They can be a decent place to park your capital but the allocation decision is not without its risks.
If you don't care to invest in anything else for a set number of years, CDs can be great for you. Insurance can help you rest knowing that the entirety of your capital won't be gone. If you are sitting on the sidelines and like readjusting your portfolio to current market conditions, bonds may not be the right fit.
The answer to this question is different for everyone so it's important to invest based on your situation. Remember that there is no right or wrong answer, just the one that makes sense to you and your comfort levels.