In the investing world, you may have heard people debate the merits of sinking their money into bonds vs. CDs. Both offer the benefit of fixed income—a type of investment that can earn interest while keeping your initial investment (or “the principal") safe. But while these investment vehicles may look similar, there are some key differences.
In this article, we'll give you the lay of the land on CD vs. bonds so you can make an informed choice about where to stash your savings.
How CD Accounts Work
First, a recap on what is a CD account and how CDs work. Certificates of deposit (CDs) are a special type of savings account that allows you to park money for a fixed term, typically three months to five years, and earn guaranteed interest on the deposit. When the term ends, you receive your initial investment back, plus the agreed-upon interest. CDs are generally geared for financial goals that are short to medium-term in nature (one to five years).
Access
You can typically buy a CD at a bank or credit union. With CDs, you're agreeing to lock up your money and not touch it for the entire term. However, if you need to withdraw your money before the end of the CD's term, the bank may charge an early withdrawal penalty and you won't collect all the interest you had expected. You may also lose the principal, depending on how early in the term you make a withdrawal.
Interest rate
With most CDs, the interest rate is fixed—meaning it won't fluctuate during the term and your return is guaranteed. Because you've agreed to lock up your money, CDs typically pay a more competitive interest rate compared to other savings vehicles, such as a savings account. The interest rate can vary depending on the length or term of the CD. Typically, the shorter the term, the lower the rate.
Risk level
CDs are guaranteed, so you can't lose money like you can in the stock market—which is why they're considered one of the safest investments you can make.
On the flip side, a bond's coupon or interest rate is guaranteed to pay semimonthly unless the bond issuer defaults, but bond prices can fall in value if interest rates rise. If you don't hold your bond for its entire duration, it's possible to sell it for less than you paid for it.
Minimum deposit
You get to decide how much you want to deposit, but the bank may require a minimum deposit to open an account. Note that RVC is one of the few institutions that does not require minimum deposits for CDs.
Contribution frequency
You cannot contribute regularly to a CD like you can with a savings account. Once you open a CD account for a specified term, you're locked in for the duration.
How Bonds Work
Bonds are a type of fixed income that pays semi-annual interest (called a “coupon") for a specific period (called “the term"). Think of a bond as a loan to a corporation or a government (municipal, state or federal). As an investor, you lend the money up front and the corporation or government agrees to pay an interest rate (or “coupon") for the term of the loan. If you hold the bond for the entire time period, you'll get your money back, plus interest when it matures.
Access
Bonds are typically purchased in an investment account and held in a risk-appropriate proportion to stocks to make up a diversified investment portfolio. Bonds are traded just like stocks, so you can buy and sell bonds whenever markets are open.
Since bond prices fluctuate in value as interest rates move up and down, you'll see the value of your bond investment fluctuate in price as well. You can sell your bond at any time, so if interest rates fall and bond prices rise, you may want to sell your bonds at a premium.
Interest rate
Bond prices are influenced by interest rates. The price of your bond can fluctuate throughout the term as interest rates move up or down. But when the bond matures at the end of the term, a bond investor will receive their principal, along with the interest collected over time.
Let's say you purchased a $10,000 bond with a coupon of 4%, paid over five years. Next year, interest rates increase by 1% and bonds issued that year pay 5%. If you wanted to sell your bond, you'd have to discount the price because the interest rate on your bond is only 4%.
That makes sense, because why would an investor purchase your 4% bond for $10,000 when they can purchase a new bond for $10,000 and earn 5%?
On the other hand, if interest rates fell by 1% next year, new bonds would be issued with a coupon of 3%. If you wanted to sell your bond, you could demand a premium price because your bond pays a higher interest rate.
Risk level
Despite the price of your bond moving up and down throughout the term of the bond, you'll get your principal investment back if you hold the bond to maturity. Think of bonds as a buffer against stock market volatility.
CDs, on the other hand, are guaranteed to pay you back your principal, plus interest at the end of the term. The risk for CDs is called liquidity risk, since your money is locked up for the term and can't be accessed without penalty.
Minimum deposit
Individual bonds are issued at a particular price (say, $1,000 or $10,000 per bond). However, most investors get their bond exposure through mutual funds or exchange-traded funds (ETFs), which can be bought without a minimum deposit. In contrast, CDs typically come with a minimum deposit of $500 or $1,000.
Contribution frequency
Bond mutual fund and ETF purchases can be set up with automatic contributions at whatever frequency your bank or brokerage account allows, such as weekly, biweekly or monthly.
In contrast, CDs require a lump sum contribution up front. You're locking in a sum of money for a predetermined period of time, and you can't make regular contributions to a CD.
Comparing CDs vs. Bonds
Now that you've looked under the hood of each savings vehicle, you might be wondering where to park your money. While the mechanics may look similar, there are pros and cons for each option.
| CDs |
Bonds |
|
| Minimum deposit |
Sometimes (depends on the financial institution) |
No (if bought as a bond mutual fund or ETF) |
| Terms |
3 months to 5 years |
3 years to 30 years |
| Ongoing contributions |
No |
Yes |
| Risk to initial investment |
None, unless redeemed early |
Price can drop in value if interest rates rise |
| FDIC-insured |
Yes, if bank is a member (up to category limits) |
No |
| Liquidity |
Typically can't be redeemed without penalty |
Can be bought and sold when markets are open |
| Flexibility |
Typically, none. Your term length and interest rate are set upon purchase (although you can buy a "no-penalty" CD). |
A lot. Bonds can be short-, medium- or long-term and can be purchased and sold at any time. |
Benefits of CDs
- • CDs have shorter maturities (terms) than bonds, so you can take advantage of interest rates over periods of three months to five years.
- • CDs sold by Federal Deposit Insurance Corporation (FDIC) member banks are FDIC-insured, making them virtually risk-free if the CD amount is under the insurance limit.
- • CDs can easily be "laddered," meaning you can purchase equal amounts of one-, two-, three-, four- and five-year terms and always have money maturing each year to take advantage of new opportunities (or to use for spending).
- • CDs do not fluctuate in price—your principal investment is guaranteed.
Potential downsides of CDs
- • CDs are typically not liquid—you're essentially putting your money in a vault for an agreed-upon period. Accessing the money early usually comes with an early-withdrawal penalty unless you purchased a bump-up CD or a no-penalty CD, which may come with a lower interest rate.
- • CDs can be difficult to manage if you have several CDs held at different financial institutions and maturing at different terms.
Benefits of bonds
- • Bonds are liquid, so you can sell your bond at any time. For investors, bonds are useful for rebalancing when stocks fall in value (selling bonds to buy more stocks to return to your original asset mix).
- • Bonds can appreciate in price. So when interest rates fall, your bond price goes up in value. Since bonds are liquid, you could potentially sell your higher-priced bonds for a tidy profit.
- • Bond terms vary in length. You can buy short-term bonds with maturities of three to five years, medium-term bonds with maturities of eight to 12 years, or even long-term bonds with maturities as long as 30 years.
Potential downsides of bonds
- • Unlike CDs, bonds can lose value. In a rising interest-rate environment, bond prices fall in value. As a rule, shorter-duration bonds are less sensitive to interest rate movements than longer-duration bonds.
- • Bond principal is not insured by FDIC. You'll only receive your money back if you hold the bond to maturity.
When to Choose a CD Account
CDs are an ideal investment if you have a lump sum of money and a short-term financial goal that's one to five years away, such as saving for an emergency fund, a child's education or a down payment on a car or home. Retirees can also take advantage of CDs as a place to park their expected annual spending for the next few years. Stocks and bonds are too risky in the short term to provide a reliable outcome. If you want to guarantee your principal amount and earn the best risk-free interest rate, CDs can be a good choice.
When to Choose a Bond
Bonds are best used as a complement to stocks in a well-diversified investment portfolio. Bonds tend to hold their value when stocks fall, which allows investors to rebalance and buy more stocks at a discount.
Investors should ideally match the bond's maturity with their investing time horizon—so if you need to access funds from your portfolio in one to five years, you may want to invest in shorter-duration bonds. Investors with a longer time horizon may be more comfortable with longer-duration bonds that offer higher yields but are more sensitive to interest rate movements.
Final Thoughts on CD vs. Bonds
CDs and bonds are types of fixed-income investments, each with pros and cons that should be carefully weighed based on your financial goals.
CDs are purchased at a bank or credit union in terms of three months to five years. They're usually FDIC-insured and your principal is guaranteed, along with the agreed-upon interest at the end of the term. They're geared toward people who want to grow their savings in the short term.
Bonds are purchased in an investment account, typically as a complement to stocks as part of a diversified portfolio. Bonds pay an interest rate semiannually (called a "coupon"), and while bond prices fluctuate with current interest rates, investors will receive their initial investment back if held to maturity.
Most investors need fixed income in their portfolio, either to cover a one-time expense in the short term or to complement their stock portfolio. Determine your goals before deciding whether to invest in CDs or bonds, and check out Riverstones Vista Capital 's CD rates and terms for your fixed-income needs.
Robb Engen is a leading personal finance expert in Canada and the co-founder of Boomer & Echo, an award-winning personal finance blog. He is a fee-only financial advisor who helps clients at different ages and stages get their finances on track and prepare for retirement. He's also regularly quoted or featured in top financial media, such as The Globe & Mail, MoneySense, The Financial Post, CBC and Global News. Robb lives in Lethbridge, Alberta, and is the married father of two young girls who keep him very busy.
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