Both CD’s (certificate of deposit) and bonds are fixed-income investments. The main difference is that bond prices can fluctuate while with a CD you’re guaranteed to get your initial investment back plus the promised interest.
CD vs. Savings Account
CD’s, as of 2018, are yielding somewhere in the 2% range while savings accounts are yielding somewhere in the 0.1% range.
Both a CD and a savings account are FDIC insured but you get the higher rates in a CD because you are giving up liquidity. Often, if you choose to cash out the CD early, you would be faced with interest rate penalties.
The higher the duration of the CD, 5 or 7 or 10 years, the higher the interest rate.
Of course the reason for these higher returns is the higher inflation risk you take on. If you hold a CD for 7 years and get 3.2% per year but inflation is 4% a year during that time then you will have lost money.
CD’s have traditionally kept up with inflation so, on a long enough time horizon, it’s unlikely that you will get crushed by having CD’s as part of your investments.
CD Rates
How do CD rates increase? When the Federal Reserve (“The Fed”) increases interest rates then the CD’s which are offered by banks or brokerage houses will have accordingly higher interest rates.
Back in the 1980’s when CD interest rates were in the double digits, so were inflation rates. Yes, you could invest $100,000 in a CD and get $10,000 but the end of the year but house prices, car prices, and other consumer items were going up in price just as fast.
CD Guarantees
Unlike a bond fund, you cannot lose money in a CD – at least not numerically. You might lose value but that has to do with inflation. You will always get what you put into a CD plus your promised interest rate.
CD’s are also FDIC insured. Bonds are not.
If you invest $100k in a CD which has a 3% rate for 5 years then you’ll get a 3% ($3,000) return for every year you hold that CD. Unless you try to access the money before that 5-year mark, there is no way that you would walk away with any less than the $100k you put into it.
Bonds, however, can drop in value which we’ll get into next.
Bonds
A bond is a securities investment where you become the lender, lending your money to a government (municipal bond) or a corporation (corporate bond) in return for a determined interest rate.
When you buy a bond fund and are trading it (selling it or buying it from other investors) then the price of that fund will be affected by current interest rates.
So, just like CD’s, bonds are affected by interest rates. But it’s important to understand that, unlike a CD, in a bond investment you can lose your initial principal, your initial investment.
My current bond portfolio is down by 1%. Meaning, I have lost the money I put into it. This wouldn’t happen with a CD unless I prematurely cashed it out.
Rising Interest Rates
As we determined above, if interest rates increase then CD rates go up accordingly which is something we are finally experiencing in 2018.
For bonds, however, when interest rates rise, their prices drop. So the value of the bonds you hold during rising interest rates will decrease.
It’s not easy predicting which direction interest rates will go. There are trends that one can assume but it’s never certain.
It’s safe to assume that in this low-interest rate environment, the most likely direction for interest rates is up. But how fast will interest rates rise? How long will they stay at current levels? What will be the relationship in the short-term between the fed funds rate and inflation?
Liquidity
I currently have $29,000 invested in a bond fund, VMLTX, and though that investment is down by $320, I could sell the fund on the secondary market and have the cash available within a couple of days.
That’s the advantage of bond funds, they can be traded much like an individual stock or any other index fund or ETF. This gives me a piece of mind which probably is irrational but hey, who said I’m rational?
If I had a 5-year CD then I would have to break the CD contract in order to access that money. A 5-year CD is a CD which needs 5 years to mature. Withdrawing money early either has an interest-rate penalty or, in some rare cases, I may lose some of my principal.
CD and Bonds Solutions
For those who still want to hold a CD but don’t want to deal with a time commitment or those who want to invest in bonds without risking the interest rate effects, here are two solutions.
1. CD Solution: Flexible CD’s
As I was researching this post, I saw a CD offered by ally Bank which has no penalties for accessing the CD early. They call it a no-contract CD but I call it a flexible CD – same shit.
If you invest $25,000 then you get a 2% interest rate on that money. (I would ignore the 11-month term – it’s probably so that they can end it after 11 months in case rates go down).
You could get as much as 3.5% these days with longer term CD’s but you’d be giving up liquidity, as we discussed. So the above no-penalty CD is a good option for someone who wants a better rate of return than their savings account without the commitment.
With options like this available there is no excuse to have your money in a traditional savings account even for a week.
2. Bonds Solution: Short-term Bonds
Just like no-penalty CD’s are the cure to liquidity problem of traditional CD’s, short-term bonds are the cure to the interest rate risk of bonds.
The longer the bond duration, the higher the impact of interest rates on it. So, a 10-year bond fund would be much more affected than a 1-year bond if interest rates go up.
One option would be to invest in short-term or medium-term bonds in order to take advantage of the higher interest rates.
From the screenshot of the bond above you can see that the yield is 2.1% – so not much better than a long-term CD but better than a no-penalty CD. VMLTX is the bond fund which I hold because of its tax advantages.
The average duration of a bond in that VMLTX fund is 2.5 years and the fund holds 5,046 individual funds; most of which are AAA, AA, and A-rated.