How the concept of bonds works
Bonds are binding contracts between a bond issuer and a buyer, enabling the issuer to take a loan from the buyer. In return, the issuer is obliged to repay the buyer at a specified interest rate for a fixed period, at the end of which the issuer has to refund the principal amount.
The main issuers of bonds are governments, municipal authorities, and large-scale corporations. Government-issued bonds are viewed as safer investments because governments hardly fail to honor their debt obligations. The reliability of municipal bonds and corporate bonds is pegged to their respective credit ratings.
How Certificates of Deposit (CDs) work
A certificate of deposit (CD) is a legally binding contract between a depositor of money and an institution (recipient of the money). It involves lending money to the institution for a fixed period in return for predetermined interest payments, usually above standard market rates. Interest yields are paid on a predetermined frequency, which is typically monthly, yearly, or semi-annually. The principal amount lent has to be returned to the depositor at maturity.
Bonds vs CDs: Differences
1. Trading: Bonds have fixed periods of maturity but there are no barriers to trading in them once they are issued. Investors holding bonds have two broad options: They can keep them to maturity or, depending on preference, sell them in the secondary market. Bond prices have a sea-sow relationship with interest rates- when one rises as the other falls and vice versa. This creates the primary demand and supply forces in bond markets.
2. Insurance cover: This is among the most attractive aspects of CDs over bonds. Each CD account is insured against potential default to a maximum of $ 250,000.
This is an assurance that should the borrowing institution fall into financial distress, the account holder will have their finances covered significantly.
On the other hand, municipal and company bonds are comparatively riskier because they are never covered by insurance. Therefore, if the issuer becomes illiquid, then bondholders risk losing their money.
3. Differences applicable in taxes: Federal bonds advance tax incentives to their buyers, which is never the case with CDs. With bonds, the Fed will tax the interest accrued, but bondholders are usually cushioned from state taxes. However, earnings from CDs interest are considered as regular income and are charged according to the corresponding income bracket.
4. Maturity period: Bonds have comparatively longer maturity dates than CDs. Bonds typically mature after 10 to 30 years. On the other hand, CDs have short life spans, which are five years on average, but in rare cases can go for ten years.
When are CDs appropriate?
- When you are convinced that interest rates are likely to remain the same or decline in the next few years: The terms of your CD contract cannot be amended once you sign up. Therefore, your payment rate per month / annually / semi-annually will remain the same throughout the contract period. Therefore, if normal bank rates increase during your lock-in period, you risk losing higher returns. CDs are therefore a better choice for an investor when they think that it is unlikely that bank interest rates will rise in the future.
- If you want to insure your principal funds: Holders of CDs have a lower risk it comes to early withdrawal of funds. This is because the penalties accruing from such withdrawals have to factor in the difference between the expected yield at maturity and interest earned prior to withdrawal. On the other hand, bonds sold before maturity tend to fetch lower prices. Under such circumstances, an investor may be forced to lower their asking price.
When are bonds a good choice?
- If you think that future interest rates will fall:
Bond yields rise when interest rates fall. Therefore, it is better to choose bonds when you are certain that interest rates will fall in the coming years.
- When you may not hold on to the end:
Investors are comparatively more disadvantaged with CDs than with bonds regarding early withdrawals. With CDs, there is no doubt that you will pay the penalty for early withdrawal. On the other hand, there are periods when bond yields rise significantly, thus fetching higher prices in secondary markets. Therefore, you will be presented with opportunities to sell your bonds at a higher price even before they mature.
- When you want to save on tax payments:
Since there is a tax reprieve that comes with bonds, you may want to take advantage of this to buy bonds. This can especially be helpful when you are in a dilemma if CDs and bonds are offering similar interest rates.
- If you are interested in long-term investment :
Since bonds can have maturity dates that are comparatively longer than CDs, you can consider taking them if long-term investment appeals to you or if you want to cushion yourself against more volatile and unpredictable assets like stocks.
Bonds and CDs are viable investments with risk levels that are relatively low. However, you should assess what you stand to gain, as well as their downsides. You should only go for an option that aligns with your investment goals.