Certificates of deposit and bonds are two types of debt securities. These instruments typically appeal to investors who are seeking income and are concerned with principal preservation. Despite the many similarities between these investment vessels, there are both advantages and disadvantages to investing in CDs or bonds for the long term.
When you buy a bond or a CD, you actually lend a government or entity a sum of money for a period of time. You receive a return of principal at the end of the loan term, but you could lose your investment if the bond issuer becomes insolvent. Bond issuers are graded by credit rating agencies; the most financially sound issuers receive the highest ratings, while troubled issuers receive low ratings. You can attempt to protect yourself by investing in seemingly safe bonds, but there are no absolute guarantees that you will get your money back at the end of the bond term. In contrast, CDs, like other bank products, are guaranteed by the Federal Deposit Insurance Corporation for up to $250,000, per account holder, per bank.
You can buy government bonds with terms lasting as long as 20 or 30 years, while bank-issued CDs typically have terms lasting no more than five years. When you buy long-term bonds you can make a long-term financial plan based on the interest you expect to earn on your bonds. With CDs, you have to shop around for the best rates every time your accounts reach maturity. There are no guarantees that you will earn as much as you earn now the next time your CD comes up for renewal.
Risk Versus Returns
Within the investment arena, federal bonds are regarded as the least risky debt instruments. This means federal bonds typically pay lower rates of interest than bank-issued CDs. Other types of bonds often pay much higher yields than CDs, but returns are relative to risk. Bonds issued by financially troubled entities may pay much higher rates than bank CDs, but these bonds are also more likely than most to drop in value over time. High-risk, high-yield bonds are not ideal for long-term savings because you could hold the bond for several years only for it to become worthless when the issuer files bankruptcy. On the other hand, low-risk bonds and CDs expose you to inflation risk. This occurs when your rate of return on a low-risk investment fails to keep pace with inflation.
If interest rates rise, you can replace your long-term bonds with newly issued bonds that pay a higher rate of return. When you do this, you get the current market value for your bond rather than it's face value. When rates are falling, you can sell bonds for profit, but you may take a loss if you sell bonds in a rising rate environment. Despite possible price fluctuations, bonds provide you with a relatively high degree of liquidity. In contrast, you cannot sell most types of CDs on the secondary market. You can cash in a CD before it reaches maturity, but in doing so you usually incur hefty fees and interest penalties. Such fees are more likely to impact people who use CDs for the short term rather than the long term.
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