Bonds vs CDs - Fixed Income Investing
- September 20, 2022
- by Angela
Do you know which securities have fixed interest and low-risk income? Do you know which securities have short maturities and which securities may offer tax advantages? These are bonds and CDs (certificates of deposit). In this article, you will find out why they are a good investment.
What is a Bond?
Bonds are securities representing debt. It is a loan that investors make to large entities, such as a government or company. When you purchase a bond, the seller promises to pay a certain amount of interest over time, in addition to the face value when the bond matures.
The safest type of bonds are issued by the US Treasury.
State and local governments issue municipal bonds. Their riskiness varies depending on the credit rating of the state or municipality.
Corporate bonds are riskier than government or local bonds, but they can also offer more attractive interest rates.
Bond funds allow you to buy a small slice of a huge collection of bonds that are managed for you. Bond funds vary by duration (30 days to 25 years) and bond type (government, muni, corporate, etc).
What is a CD?
A CD (certificate of deposit) is a type of savings account offered by banks. A CD requires you to keep your money in the account for a certain period - usually a period of several months to five years. In exchange for the commitment of funds, the bank promises to pay a fixed interest rate that is much higher than a traditional savings account.
Sometimes interest on CDs is paid every month, and some banks choose a different interest payment schedule, such as a three-month or six-month period.
CDs may charge an early withdrawal penalty if you withdraw money before the CD’s maturity date. For example they may charge one year of interest. However some banks do offer penalty-free CDs but the rates will be lower. So if you might need the money soon make sure to read the details of the offer before setting up the account.
Bonds vs. CDs - Key Differences:
There are a few differences between bonds and CDs:
- Bonds are traded in the markets, but CDs aren’t - Bond values are linked to interest rates. If interest rates happen to fall, bond prices rise. The reverse also happens (called interest rate risk) where the market value of the bond drops when interest rates rise. However if you hold the bond to maturity you will always get the face value (assuming the bond issuer does not default).
- CDs are insured, but bonds are not - CDs come with FDIC / NCUA insurance of up to $250,000 per account holder. This means if the bank or credit union fails the federal government will step in and cover the balance.
Municipal and corporate bonds don't come with any type of insurance protection. If they run into financial difficulties and are unable to pay back the bond’s face value when it comes due, you are out of luck. On the other hand, US treasuries are considered almost as safe as CDs because they are backed by the “full faith and credit of the US government”. While US Treasuries are not officially insured, it is generally accepted that the US government is always going to meet its obligations.
- CD’s are taxed as short term income, Bonds can vary - CDs are taxed as ordinary income. If you are in the 24% tax bracket, your tax would be $24 for every $100 in CD interest payments collected.
With bonds, the tax treatment depends on the type of bond. Interest on US Treasury bonds is taxed on your federal return, but not on state or local returns. This makes US Treasuries more attractive to investors living in states with high state and local income taxes.
Municipal bonds also have tax-saving benefits. The proceeds of these bonds are fully exempt from federal taxes and may be exempt from local and state taxes if they are issued by the state where you live. For example California municipal bonds are tax exempt federally and to those residing in California. If you are in the 24% tax bracket (federal + California) you can multiply the California muni bond interest rate by 1.24 to get the “effective after tax interest rate”. This is why muni bonds generally have a lower interest rate than other bonds, since the after tax interest rate gives them a boost.
Note that if you sell a bond before it matures (or shares in a bond fund) you are also taxed on the change in value. If the value went up because rates dropped, you would be taxed on any capital gains. If you held the bond for more than 1 year it would be considered long term capital gains. If you held it for less than 1 year it would be considered short term capital gains, taxed as ordinary income.
- CDs usually have shorter maturities - most bonds have maturities of 10 years or more. Some bonds have maturities of 20 and 30 years, while CDs usually have maturities of up to 5 years, although some banks have maturities of up to 10 years.
When to consider CDs:
Given that CDs have certain advantages over bonds, CDs should be considered in the following cases:
- You don't want to risk losing your principal - you can't lose your principal with a CD. You may pay an early withdrawal penalty, and the fee is usually calculated as part of the interest you have accumulated after a certain period. It may be that the interest deduction doesn't affect your principal at all, because it all depends on how long you've held the CD.
As for bonds, the situation with interest is a little different. If you want to sell the bond before it matures and if at that moment interest rates are higher than what you are paying, you will have to sell yours at a discount to attract a buyer. If you want stability, a better option is to open a CD.
- You have a short-term investment horizon - if you need to park money for a short period of time and you don’t want to deal with price fluctuations or transaction fees CDs make a lot of sense.
When to consider Bonds:
Bonds are riskier to invest in, but you can invest in them if:
- You value liquidity - unlike CDs that are locked in, you can sell bonds at any time if your goals and needs change. You can also realize a small capital gain if rates happen to drop.
- You want to reduce the taxes you pay on investment income - federal and municipal bonds offer tax benefits that will leave you with more money in your pocket than a CD offering the same interest rate.
- You have a long-term investment horizon - many bonds have maturities of 10 to 30 years and are great for long-term investors who want to hedge against stock market volatility.
An investor who has had bonds for 30 years can distribute funds for his investment portfolio. This investor could technically continue to buy CDs every 5 or 10 years to protect himself from market volatility, but that would be extra work. Investing in a bond fund using your 401(k) or IRA account is the easiest way to own bonds.
Conclusion: Bonds and CDs have their pros and cons, and it's up to you to decide what you want to invest in.