Published in: Banks | Jan. 1, 2020
Are CDs Safer Than Bonds?
By: Maurie Backman
If you're the risk-averse type, it helps to know where the safest place for your money is.
No matter how much you earn, you should have an emergency fund with enough money to cover three to six months of living expenses. That emergency cash should be left in a traditional savings account, where your principal deposit is protected.
But what if you're looking for a relatively safe investment for the cash you've amassed beyond your emergency fund? If you stick it in a regular savings account, you won't earn much interest on it. Another option is to put it into a certificate of deposit (CD) or invest it in bonds where you'll likely earn a lot more interest without exposing yourself to too much risk. The question is: Which is a better -- and safer -- choice?
What is a certificate of deposit?
With a CD, you agree to lock up a certain amount of money for a predetermined period of time. In turn, you're guaranteed a certain interest rate on that money, unlike a savings account where interest rates can fluctuate, for better or worse, throughout the year.
For example, you might put $5,000 into a two-year CD with a 2% interest rate. You agree to keep that money in the bank for two years, and you're guaranteed that 2% interest rate, even if rates drop drastically.
If you cash out your CD before its term ends, you'll risk a penalty that varies, but is usually the equivalent of several months' interest. But your principal deposit in that account is protected provided it doesn't exceed the FDIC limit of $250,000 per depositor (and really, you wouldn't want to put anywhere close to that level of cash into a CD anyway).
What are bonds?
Bonds are debt instruments that are issued to raise funds. Corporate bonds are issued by companies to secure capital for things like expansion and product development. Municipal bonds are issued by cities and townships for projects like park cleanups or road improvements.
When you buy bonds, you agree to lend the issuer a certain amount of money for a predetermined period of time. In exchange, the issuer agrees to pay you interest twice a year at a preset rate.
For example, if you buy $5,000 of a company's 10-year bonds with a 4% interest rate, you agree to give that company your money for 10 years, and it agrees to pay you $200 in interest annually ($100 twice a year) until your bonds mature, at which point you get your initial $5,000 back.
How do CDs and bonds differ?
CDs and bonds differ in a few ways:
- CD deposits are FDIC-insured. This means your principal is protected. Bonds are not FDIC-insured. If a bond issuer goes bankrupt, your bonds' value could drop. If you buy $5,000 worth of bonds but their value declines, you could wind up only getting repaid $3,000 when your bonds come due. And, there's the possibility that your issuer will stop making interest payments if it encounters financial difficulties, whereas you're guaranteed interest on your CD.
- You won't be penalized for selling your bonds before their term is due. But you do get penalized for cashing out a CD early. If you buy $5,000 in bonds but need that money several months later, and you're able to get the same price for your bonds, you won't lose money by not waiting out your bonds' term. (Keep in mind, though, that you may not be able to get that same price.)
- Your bonds can increase in value. You may be able to sell your bonds for a higher price than you initially paid. With a CD, you'll earn interest, but you can't turn a principal deposit of $5,000 into a higher principal.
CDs vs. bonds: What's the safer investment?
In the grand scheme of investments, both CDs and bonds are relatively safe.
That said, CDs:
- Offer the protection of FDIC insurance while bonds don’t.
- Are a more liquid investment.
You can cash out a CD at any time and still get your principal back, minus whatever interest penalty applies. To sell bonds before they come due, you need a buyer. If you don't find one, you're out of luck. And while bonds issued by a reasonably reputable company or municipality may not be so hard to sell, if that issuer falls upon hard financial times and gets downgraded to junk territory (a designation meant to indicate that the bonds in question are generally not suitable for investors), you may not be able to move those bonds out of your portfolio.
But bonds, to some degree, do give you more control over your money, as you can sell them you want or need to cash out your investment without being penalized -- assuming there's a market for them.
It is worth remembering that both CDs and bonds expose you to what's known as interest rate risk. Any time you lock your money away for a preset period of time at a fixed interest rate, you run the risk that you'll lose out on the opportunity to earn more interest a few months down the line.
For example, you could lock in a two-year CD at 2% interest. But what if your bank then offers that same two-year CD at 2.25% interest two months later? At that point, you're stuck with that 2%. Similarly, you might buy $5,000 of 10-year bonds at 4% interest, and six months later, that issuer offers the same bonds with the same 10-year term for 4.5% interest. Once again, you're stuck.
Ultimately, you can still rest assured that both CDs and bonds are fairly safe investments. If you're the risk-averse type, either could be a suitable choice for you.
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