CDs vs. Bonds: What’s the Difference?

Photo illustration to accompany article on bonds and CDs

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Having a strategy that involves spreading your investments across different assets can help you mitigate any volatility in the market—and there’s been plenty of that in 2020.

With the economy facing unprecedented challenges resulting from the coronavirus pandemic, it’s logical to seek out stability and opt for lower-risk investments in a portion of your portfolio, whether you’re already a seasoned investor or just getting started.

As long as you have an emergency fund and don’t have debt piling up, you don’t want to make the mistake of waiting for the “best” time to invest when it’s for the long-term. It’s generally true there’s no better time to start investing than now. But what if “now” is during an ongoing global health crisis?

When you’re starting out, or when you’re uncertain, you can invest in low-risk assets that you understand. Two straightforward vehicles that investors turn to for security are certificates of deposit (CD) and savings bonds. 

All You Need to Know About Investing in Low-Risk Options

There are many safe investment options to grow your money, which is why it’s important to do some research and figure out which ones are best for you. But there’s a catch: conservative investments earn smaller returns.

That may be fine if your goal is to preserve your investment, build your interest income over time, and take some bite out of inflation, which is the gradual erosion of buying power over time. An increasing rate of inflation means your money won’t go as far as it once did, and therefore eats into your savings if they don’t grow at the same rate. 

Among FDIC-insured (Federal Deposit Insurance Corporation) deposit accounts and a few other low-risk investments, here are two ways you can keep your savings secure and growing. 

CDs

 A CD is a type of savings account with a fixed interest rate and typically has a fixed date of withdrawal, known as the maturity date. This is the length of time you agree to leave your funds in a CD account. 

Locking your money away in a CD is very similar to opening a standard bank deposit account, like a high-yield savings account—except that you can’t access it until a certain date. 

This usually results in higher returns than a savings account would offer. However, CD rates are at an all-time low in the current environment — at times, even lower than savings accounts. According to the FDIC, the national average rate for a 12-month CD was 0.22% at the end of July, down significantly from 0.64% around the same time last year. Investing in a CD returning a lower interest rate than the inflation rate means you’ll lose money over time. However, inflation is staying well below the Federal Reserve’s 2% target, according to the Brookings Institution.

Savings Bonds

A savings bond is essentially a loan to the government, and in turn, the government pays you a modest return on that loan. The interest on a savings bond typically compounds semi-annually and grows every year for 30 years. 

The Treasury sells two types of savings bonds through its website: the EE bond and I bond. 

An EE bond has a fixed rate of return, whereas an I bond has both a fixed rate and a variable rate to adjust with inflation. The inflation rate typically changes every six months, according to the U.S. Department of Treasury. This means the I bond is adjusted for inflation but has no guarantee of value at maturity.

The EE Bond comes in two forms, paper or electronic. Paper bonds issued between May 1997 through April 2005 were purchased at half its face value. During that time frame, you purchased a $50 EE bond for $25. 

Electronic EE bonds are purchased at face value, so a $50 purchase for a $50 bond. You can buy any denomination between $25 and $10,000. Either way, a paper or electronic EE bond will be worth at least double its purchase price when it reaches its 20-year maturity. Meaning, whatever your original investment cost, it will double after 20 years and continue to earn interest for up to 30 years.

The EE electronic bond starts to earn interest on the purchase price right away. If the interest it earns over those 20 years does not result in at least twice the value, the Treasury guarantees a one-time adjustment at the 20-year mark to make up the difference.

Pro Tip

If you’re looking to take full advantage of a savings bond or CD account, don’t withdraw your money until it matures. Otherwise, you may lose part of your original investment or any accrued interest to cover the early withdrawal penalty.

Savings bonds come with little to no risk, but they also can come with little to no return if you don’t hold onto them for at least 20 years. They can be a good investment if you are willing to tie up your investment for a long time.  

CDs vs. Savings Bonds

Is a CD or a savings bond a better place to park your money? Well, it depends. Understanding your financial goals, risk tolerance, and liquidity needs will help you determine which investments are right for you.

Neither investment type is suitable for funds that you want to access soon. “CDs and savings bonds are intended for medium to a longer-term period of time. They’re not the same as your checking or savings account. The money you place in a CD or bond should be stable that you’d like to earn a little bit of interest on,” says Melissa Joy, certified financial planner and president of Pearl Planning Wealth Advisor in Dexter, Michigan.

Here are several other factors to consider when comparing and contrasting CDs and savings bonds.

Risk

Both are safe choices, but CDs are slightly safer since they’re insured by the FDIC, Joy says. As long as you stay below the $250,000 insurance limit, you’re guaranteed accrued interest on top of your original investment when you hold a CD until maturity. 

If you withdraw your money from a CD account early, you might have to forfeit a portion of the interest you earned. The cost of an early withdrawal penalty depends on the length of the CD term and the bank you opened the account with.

Savings bonds are also extremely safe investments. Although they’re not insured up to a certain amount, the U.S. government has never defaulted on its debt. 

“CDs and savings bonds are probably as risk-free as you can get in the investment world. Among CDs and bonds, if you are very risk-averse, I would recommend leaning towards CDs,” says Amy Richardson, a certified financial planner with Schwab Intelligent Portfolios.

Taxes

It’s crucial to take taxes into account when investing as it can take the biggest bite out of your returns. The principal amount you invest in a CD is typically not taxable, but any accrued interest is fair game. The only way you can avoid paying tax on interest is if a CD is purchased in a tax-advantaged account like a 401(k) plan or an individual retirement account (IRA).

The amount of taxes you pay on CD interest is based on your tax bracket, which depends on your yearly income.  For example, if you buy a $5,000 CD yielding 3% and you’re in the 12% federal tax bracket, the annual interest will be roughly $150, and you’ll end up paying 12% of that, or $18, in federal taxes, plus any state or local taxes.

Many people find bonds attractive because any earned interest is typically only taxable at the federal level and not subject to state or local income taxes. This can be especially beneficial for taxpayers who live in states with high income taxes. 

If you’re stuck on whether to store your cash in bonds or CDs, use an online CD calculator and savings bond growth calculator to see your returns after taxes and compare the two. 

Return on Investment

It’s important to keep in mind interest rates on savings bonds fluctuate with the market, especially over long periods of time. You’ll earn less return in a low-interest environment, but will always earn at least double your investment after 20 years if it’s an EE savings bond.

If a savings bond is cashed in and sold before it reaches maturity, it might be worth more or less than its face value, depending on financial market conditions. 

That’s why many are attracted to CDs, which offer fixed interest rates for fixed terms. CD rates vary across different financial institutions, but generally, the longer term, the higher the rate.  

Bonds can be a powerful diversification tool and, in recent years, a beneficial vehicle for stashing away money and growth. 

Since the EE savings bond guarantees to double your investment after 20 years, that equals a compound annual return of about 3.5% on your investment. (If a savings bond is cashed in and sold before it reaches maturity, it might be worth more or less than its face value, depending on financial market conditions.) 

In comparison, from 2000-2007, 5-year CD rates ranged from 3.45%-5.95%. Since 2008, however, CD rates have not breached the 4% mark. 

Right now, 5-year CD rates range from 0.60%-1.10%. If you are in the market right now to park your savings in either a savings bond or a CD, the EE savings bond will give you the better return. The issue is, you’ll have to wait 20 years to see your return to fruition. A savings bond cashed early will have little return accrued. However, this low-interest rate environment isn’t expected to last forever. You could ladder your investment through CDs and possibly see a better return than savings bonds over the next 10 to 20 years, especially if interest rates go back up to what they were in the early 2000s. 

Also, the maximum you can invest into a savings bond is $10,000. If you have more cash to invest, you may want to consider diversifying into bonds and CDs. 

If you are not sure when you will need your investment back, a CD is a good choice since you don’t have to wait 20 years to cash in. 

Investing During Uncertain Times

Investing may not be top of mind right now, but it’s smart to continue investing in your future or to start —  as long as you’re not risking money you can’t afford to lose.

The earlier you invest, the greater your potential return because of compound interest. If you’re unsure or nervous about investing now, then don’t do it. Instead, ease into it by reading and learning until you’re confident with the idea. 

“Know your options. CDs and bonds are two great vehicles for safety. They also are kind of co-mingled with the strategy of just having cash and liquidity on hand,” Joy says. “Before you get into the weeds of investing, first make sure you have your basics and emergency reserves.”

Times like these are a reminder of how important savings are. It’s never too early or too late to start, even if it’s just putting aside a small amount every week. It’ll build up over time. 

See if now is the right time for you to start investing and spend some time thinking about some possible worst-case scenarios.

For example, ask yourself what you would do if you lose your job and what other income sources you could pursue. Could you make lifestyle changes and live below your means if you had to?

Above all, have a plan and set reasonable expectations to prepare for any possible good and bad times ahead.