CDs vs. Bonds: What’s the Difference?

Certificates of deposit (CDs) and bonds are both safe investments. Both offer modest returns but carry little or no risk of losing your principal. They are much like interest-paying loans, with the investor acting as the lender. Bonds and the best CD rates typically pay better than traditional savings accounts. However, they differ in crucial ways that you need to know when deciding where to park your funds.

For most individual investors, CDs can play a useful role as a very low-risk part of a fixed-income portfolio or a place to park cash while earning a bit of interest. Bonds are more complex but can offer higher yields for those willing to take on a bit more risk. Many investors get bond exposure through mutual and exchange-traded funds, which provide professional management and diversification.

The right mix of CDs, bonds, and bond funds depends on your financial goals, time horizon, and risk tolerance. A trusted financial advisor can help you navigate the trade-offs and build a fixed-income portfolio suited to your needs. Understanding the critical differences between CDs and bonds is an important foundation for making informed investment decisions.

Understanding CDs and Bonds

CDs

Certificates of deposit (CDs) are available from banks or credit unions and work much like savings accounts but offer a slightly higher interest rate. In return, the holder agrees to let the issuing financial institution keep and use their money for a set period. That period can be as short as six months or as long as 10 years. Extended holding periods offer higher interest rates.

CDs are as safe as an investment gets. The Federal Deposit Insurance Corporation (FDIC) guarantees them up to $250,000, so even if the bank should fail, you'll recoup the principal up to that limit.

One risk you face with a CD is inflation. If an investor deposits $1,000 in a CD for 10 years, and inflation rises over those 10 years, the buying power of that $1,000 isn’t what it was at the time of the deposit. CD interest rates increase with inflation because the bank must offer a better return to make its CDs competitive. So, buying a long-term CD might be a great deal in times of higher interest rates. However, locking in money when interest rates are low could look like a raw deal should interest rates rise.

As such, a CD is a great place to park some money you don’t need without fear that it will disappear. At worst, the money won’t grow as fast as inflation.

There are many benefits to CDs. One of the reasons that they are so popular is because of their safety and guaranteed returns.

A CD is a type of bank account, which means it is covered by the FDIC. If your bank isn't able to return the money you've deposited, the FDIC will reimburse you for up to $250,000. CDs also offer certainty. Your interest rate is locked in when you open the account. If market rates fall, your CD will keep its high interest rate, earning more than other bank accounts.

However, that certainty can also be a drawback. If rates rise, your CD will stick with its lower rate. The only way to boost the rate is to take your money out of the account and pay any early withdrawal penalties. It's also worth noting that the safety of CDs comes at a cost. Other investments, including many bonds, will offer better returns in the long run.

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.

Pros and Cons of 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.

Safety and Liquidity

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 very safe and potentially liquid depending on their maturity they can each be a fit for investors depending on their goals, willingness to research, and access in the marketplace.

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. The returns will usually be very modest relative to other investments but both offer the ultimate in investment safety with the lowest risk among your options.