Editor’s Note: While there is a type of CD that is a “brokered CD,” which is purchased from a brokerage firm and held in a brokerage account, this story provides a comparison of bonds to traditional or regular (not brokered) CDs.

Investors looking for a reliable, low-risk source of income frequently choose bonds and certificates of deposit (CDs). While these two investing vehicles share many similarities, understanding their differences is key when deciding which is the best fit for your financial goals.

The information below will help you understand bonds vs. traditional CDs and how they can both fit into your strategy for saving and investing.

What Are Bonds?

Bonds are securities that represent loans to companies or governments. These investments are a type of fixed income instrument issued by entities like the U.S. Department of the Treasury, local governments and companies. These entities use bonds for various purposes, including funding special projects like improving highways, investing in schools and building hospitals. Companies may use bonds to provide cash flow or finance debt.

How Does a Bond Work?

When you buy a bond, you lend your money to a corporate or government entity for a fixed period. In return, the bond issuer pays you interest for a set period. At the end of the period, the issuer returns the money they borrowed from you—called the principal.

What Are Certificates of Deposit?

Certificates of Deposit are deposit accounts held at a bank or credit union. Think of a CD as an alternative to a savings account to earn interest on your money. Yet, unlike a savings account, a CD requires that you commit your savings for a specific period to earn the interest.

How Does a Certificate of Deposit Work?

Like bonds, CDs have fixed terms. Also, like bonds, CDs pay a fixed rate of interest over the term of the deposit. But, unlike bonds, the interest payments are generally reinvested, providing compounding returns. At the end of the term, investors get back their principal plus the accumulated interest. Investors can then roll their funds over into a new CD or do what they please with the cash.

Bonds vs. CDs: Major Differences

While bonds and CDs are both considered fixed-income investments, that’s usually where their similarities end. The differences between the two include access, rates and risk:

  • Access. CDs are commonly purchased from banks or credit unions, while bonds are often purchased via brokerages. Investors can buy bonds individually or through bond mutual funds and exchange traded funds (ETFs) through brokerage accounts.
  • Minimum investment. CDs offer low barriers to entry with minimums as low as $0, although it’s common to find a minimum deposit requirement of $500 or higher. When you buy individual bonds, you purchase them in $1,000 increments. You can also buy bond ETFs or mutual funds in smaller amounts.
  • Liquidity. CDs have a set term and there’s often an early withdrawal penalty for accessing funds before maturity. Bonds can be bought and sold on the secondary market before their maturity date.
  • Risk. While CDs are insured by either the FDIC (Federal Deposit Insurance Corporation) or the NCUA (National Credit Union Administration) for up to $250,000 per depositor, for each ownership category, in the event of a bank failure, bonds have varying risk depending on the type of bond you purchase. Treasury bonds are insured by the federal government and are relatively low risk. Municipal and corporate bonds have varying risk levels depending on the bond’s rating (a factor of the issuer’s creditworthiness). Bonds also expose investors to both interest rate risk (how a bond’s value responds to a rise or fall in interest rates) and credit risk (the issuer’s creditworthiness). In contrast, CDs have little risk to the principal.
  • Rates. CDs may offer slightly higher annual percentage yields (APYs) than a typical savings account. Traditionally, a CD with a longer term pays a higher interest rate; however, the economic uncertainty introduced by Covid-19 means this isn’t necessarily true. Bond rates vary depending on the type of bond you purchase. Bonds with high levels of security, like Treasury bonds, offer modest rates of return. Corporate and municipal bonds can offer much higher rates than CDs because of their relative risk.
  • Rate fluctuation. CD APYs typically rise as interest rates go up. This is partly true because banks need to offer an incentive for customers to lock up their funds for a fixed term, versus the liquidity of a regular savings or money market account. However, when interest rates rise, bond prices decrease. That’s because new bonds will come into the market offering higher interest rates, making your bond with its lower interest rate less appealing to other bond investors. Then, when interest rates fall, bond prices go up since bonds yielding a higher interest rate will be more valuable than new bonds issued at lower rates of return.

How Bonds and CDs Compare

Since bonds and CDs can seem quite similar on the surface, it helps to compare them side by side. The chart below can help you review the features of each when you’re deciding which will better meet your savings and income goals.

CDs Bonds
Who issues CDs and bonds? You purchase CDs directly from a bank or credit union. Bonds are issued by three main types of entities: the federal government, municipalities and corporations.
How is your money protected when you invest in CDs and bonds? The bank or credit union you purchase the CD from insures your investment through the FDIC or the NCUA, in the event of a bank or credit union failure. While Treasury bonds are insured by the federal government, corporate bonds carry no insurance and run the risk of default if the company goes bankrupt. Some municipal bonds come with third-party insurance but are otherwise uninsured.
How do the terms of CDs and bonds compare? Average terms range from 3 months to 5 years, although there can be CDs with terms as short as 30 days or as long as 10 years or more. Average terms range from 1 year to 30 years when bonds are issued. Bonds purchased on the secondary market may only have a portion of their initial terms remaining.
When do CDs and bonds pay investors their interest? Interest usually is paid at CD maturity. Some CDs allow interest to be paid monthly. For zero coupon bonds, interest is paid at bond maturity. For regular bonds, interest is paid at regular intervals until bond maturity.
What happens if I need to cash in my CD or bond before maturity? There’s usually an early withdrawal penalty for CDs. Penalties vary based on term and can range from 90 days’ accumulated interest on up, meaning you could lose principal on a shorter-term CD. Bonds trade on secondary markets similar to stocks, but you could lose principal when you sell before maturity if interest rates have gone down.

When Bonds Make More Sense

There are two key reasons when bonds may make better sense for your portfolio:

  • Steady income. Since most bonds pay a regular “coupon” or interest payment, bonds are valuable for investors who want a fixed income at set intervals. A steady income stream is useful for investors in retirement or who otherwise desire a predictable amount of income over a certain period.
  • Hedge stock market volatility. If you already have an investment portfolio—perhaps one of your retirement accounts—it’s likely you already own bonds in some form or fashion. Whether through mutual funds, ETFs or even individual bond purchases, bonds can offer a “buffer” to help your portfolio weather the stock market’s fluctuations over time. As you near retirement, you can shift your portfolio to a heavier concentration in fixed income investments and a lower concentration in stocks to help preserve your accumulated savings and still enjoy modest returns.

It’s important to note that, as with a portfolio of stocks, investors should have adequate capital to invest in building a diversified bond portfolio. A conversation with a financial advisor can help you choose bonds with varying issuers, rates, risk and maturity.

When CDs Make More Sense

As CDs typically offer lower rates of return and lower risk, here are two instances where they may work better for your financial goals than bonds:

  • Short-term goals. Since CDs offer high levels of customization—offering investors the ability to choose various CD types, terms and rates—CDs are ideal tools for short-term savings goals. If you want to secure funds for a significant purchase like a house down payment yet earn some additional interest, a CD can help investors keep savings at arm’s length while earning a better-than-average rate of return.
  • Risk aversion. Since CDs come with FDIC or NCUA insurance, the risk to your principal investment is low. For those in retirement and taking a distribution from a pension, IRA or 401(k), CDs can help generate a return on your funds over a short period until you need to put those funds to work. Other investors might prefer the peace of mind that comes with knowing their funds are with an institution they trust in their local neighborhood and be willing to exchange the higher potential rate of return from bonds for the lower rate with a CD.

If you want to put your money safely to work while maintaining liquidity. This strategy allows you consistent access to available cash without penalty, with CDs maturing at regular intervals.

Bottom Line

Both bonds and CDs offer investors low risk with a reasonable rate of return. And both can play important roles in your diversified portfolio. In some situations, CDs may be the better choice for shorter-term goals, while bonds may be part of a longer-term strategy.

CDs don’t increase in value as bonds could when interest rates fall, although CDs would pay the established higher interest rate for the duration of their term. And there’s less risk involved. Unlike bonds, the return on fixed-rate CDs isn’t subject to interest rate fluctuations or the issuer’s creditworthiness. For investors looking for low risk with modest returns, CDs are likely the better choice.

On the other hand, investors looking for a steady stream of income with enough capital to build a diversified bond portfolio may fare better with bonds. With higher rates than the average CD, bonds offer the benefit of regular payments in predictable amounts. And you can trade bonds on the secondary market if you need access to your principal.