CDs vs. Bonds: Which Is the Best Option?
/By Shelley Murasko
Many of my clients have favored CDs over bonds in recent years. As I write this article, CDs and bonds offer the following rates:
CDs
· 6 months 5.2%
· 1 year 5.1%
· 2 years 5.1%
Bonds
· 1 year 4.6%
· 5 years 3.8%
· 10 years 3.6%
When comparing these two financial investment options, the higher CD rates seem to indicate CDs as the clear winner.
Take a moment, though, to consider the long view. Specifically, think about reinvestment risk: the risk tied to how well you can reinvest your money in the future. While it might be nice to lend money to a bank for 6 months and capture the top interest rate of 5.2%, we can’t be sure of what the available interest rate will be 6 months from now. If the U.S. were to enter a recession, for example, we could see rates drop well below 3%.
Therefore, as you go about choosing how you’d like to “lend” your money in the form of CDs or bonds, it’s wise to give reinvestment risk some consideration.
To do that, let’s step back for a refresher on what makes up a CD or bond.
What Is a Bond?
According to Investopedia, a bond is defined as a “debt instrument and represents a loan made to the issuer. Governments (at all levels) and corporations commonly use bonds to borrow money.”1
In other words, a bond is simply a “loan” to another party. As with any loan, the most important features to consider are the credit quality of who you lend to and the period of the loan (also known as the term of the loan).
Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall, and vice-versa.
In addition, bonds have maturity dates at which point the principal amount must be paid back in full or risk default.
What Is a CD?
A certificate of deposit, or CD, is a savings product that earns interest on a lump sum for a fixed period. CDs differ from savings accounts because the money must remain untouched for the entire term or the investor risks penalty fees or lost interest.
CDs usually have higher interest rates than savings accounts as an incentive for lost liquidity. As a result, it pays to shop around for the best CD rates. When searching, you can often find better rates at lesser-known banking institutions. Also, it’s important to make sure your CD is FDIC insured. This protects you from losing your investment. Thus, if the bank defaults, you’ll get your money back in its entirety despite the bank’s problems.
Both bonds and CDs are “fixed income” instruments since they traditionally pay a fixed interest rate to debt holders.
Don’t Forget About Inflation
Although CD rates might seem attractive, remember that they tend to have negative return relative to inflation. Since 1973, CDs have resulted in a negative inflation-adjusted return 49% of the time. During this same timeframe, bonds have been negative inflation-adjusted only 21% of the time. Since one of your key goals as an investor should be earning return to at least maintain purchasing power, it’s crucial to consider inflation-adjusted return.
If you’re retired, it still makes sense to keep at least one year of your cashflow needs in a cash equivalent investment like a CD. However, the frenzy to find the best CDs each year and drive all over town for seminars about CD return does seem a little silly — especially when you realize that you’re likely seeking a negative-returning instrument.
The Importance of Your Timeline
To decide whether to go with CDs vs. bonds, you may want to consider your timing. In other words, when will you need the money? If you’re socking away cash to pay taxes in 6 months, then a 6-month CD might be the perfect fit.
On the other hand, if you’re planning to use your money on a car that you plan to buy in 5 years, then the 5-year bond paying 3.8% might serve that purpose better.
How Long Will Today’s Higher Yields on Fixed Income Last?
Yields are higher on bonds today and, for now, seem to be moving upward. Therefore, bonds have higher expected returns and, thus, a better cushion if bond valuations decline.
It’s important, however, not to get caught up in the expectation that rates will remain where they are currently. We really have no idea what rates will look like 6 months or a year from now. The past shows a very bumpy trend for rates, which is something no one can predict.
According to most economists, an economic downturn is expected by markets in late 2023. With that in mind, it may be a good time to reassess your fixed income portfolio and make sure you’re invested across various terms.
Consider the trade-offs of maximizing interest today by over-weighting in CDs compared with moving out on the yield curve. This may allow you to take advantage of rates that are higher on bonds than they have been in years.
Best Practices for Investment Timing
Of course, the best practice is to align the timing of the fixed income with your approximate timeline, especially if you’ll need the money relatively soon.
For needs within a year or so, CDs remain an appropriate option. On the other hand, short-term bonds (those which mature between 1-5 years) can work for needs within the next few years. If your withdrawal needs go beyond 5 years, intermediate term bonds might make sense.
In addition, you can align your timing by choosing an appropriate bond fund. For example, a short-term bond fund will hold bonds that mature within 5 years. This gives you the advantage of holding a variety of bonds across different types of lenders with various durations.
The bond fund managers will do the hard work of determining which bonds to purchase and when to sell out of a lower interest rate bond to move to a bond paying higher interest. As a sensible investor with a moderate or growth-oriented risk tolerance, you can start to look beyond bonds to stocks once the need for money from your portfolio exceeds 10 years.
From 1950-2022, a diversified S&P 500 stock fund outperformed bond funds 99% of the time over rolling 10-year periods. They also outperformed bonds by 5%. Stocks clocked in at an average 11.1% return while bonds returned 5.5% during that period.2
While FDIC-insured CDs with a guaranteed rate of return might seem like a promising investment option for the long run, the history proves otherwise. Like other fixed instruments, CDs should be selected with timing of cashflow needs in mind. Once your time horizon moves beyond 10 years and your temperament for risk is reasonable, stock investments might be the better option for the long haul.
Wondering whether your investments line up with your time horizon? Give us a call to discuss your options. We’re here to help and look forward to meeting with you!
Sources
1. Fernando, Jason. (Mar. 09, 2023.) Investopedia. “Bond: Financial Meaning with Examples and How They Are Priced.”
2. J.P. Morgan Asset Management. (Dec. 31, 2022.) J.P. Morgan. “Guide to the Markets,” page 64. Bloomberg, Strategas/Ibbotson.
