What are Bonds?
A bond is a debt security that investors can purchase from other investors or directly from the organization that issues the bond. When an organization, such as the federal government, a local government, or a corporation, wants to borrow money, it can do so by issuing a bond.
There are many types of bonds, such as government bonds, corporate bonds, high-yield bonds, and municipal bonds. Each type has unique characteristics and a different risk profile.
When an organization issues a bond, it will choose an interest rate (also called a coupon) and a maturity date for the bond. The interest rate determines the amount that the borrower will pay to investors each year. The maturity date determines how long the borrower will continue to pay interest and when the borrower will return the principal to investors.
For example, a company might issue a bond with an interest rate of 4% and a maturity of 30 years. The company promises to pay interest twice a year.
If an investor buys a bond worth $1,000, they will give the company $1,000 in exchange for the bond. The company will pay the investor $20 twice a year until the bond matures. Once the bond matures, the company will pay the final interest payment and return the initial amount paid by the investor of $1,000.
Over 30 years, the investor will receive $1,200 in interest and will ultimately get back the initial amount they invested of $1,000.
Investors who do not wish to hold the bond until maturity can sell it to other investors.
Bond Risks
Before investing in bonds, it is important to understand the risks associated with them.
Default risk: The company or municipality that issues the bond may not be able to pay it back. Looking at the credit rating of the borrower can help reduce the chances of default.
Interest rate risk: When you purchase a bond, the interest rate for the bond is usually locked in. However, market interest rates are constantly changing. If you buy a bond when interest rates are low and rates later rise, you will still have a bond that pays a low interest rate. This can diminish the value of the bond if you need to sell it to another investor before the bond matures.
Inflation risk: Since you receive fixed interest payments annually from the bond, inflation decreases the value of those payments over time. If inflation rises significantly, it may erode the purchasing power of each interest payment you receive.
Liquidity risk: If you want to sell a bond before its maturity, you will need to find another investor willing to buy it from you. There may be times when no one is willing to purchase the bond, forcing you to hold it until maturity. This risk is called liquidity risk.
What is a Certificate of Deposit?
A Certificate of Deposit, also known as a CD, is a time deposit account that you can open at a bank.
When opening a CD, you will choose a maturity date for the CD, which usually ranges from six months to five years from the date the account is opened. You will also decide how much money you want to deposit into the CD.
The bank will pay interest on your CD account based on the amount you deposited and the interest rate offered. Typically, longer-term CDs pay higher interest rates than shorter-term ones. With most CDs, the interest rate is locked in for the life of the CD when the account is opened.
One of the main advantages of CDs is that they are insured by the FDIC. This insurance helps protect customers in case the bank fails. This makes CDs less risky than bonds, but it also means they pay lower interest rates.
The FDIC provides coverage of up to $250,000 per depositor for each account type at covered banks. You can increase your FDIC protection by spreading your balance among several banks, keeping the balance at each bank below $250,000.
When
The CD matures, you will have the opportunity to withdraw your funds from the account or add additional money. If no changes are made, most banks will automatically transfer your account balance to a new CD.
If you wish to withdraw your funds from the CD before its maturity, most banks will impose a penalty fee. The amount of the fee usually depends on the amount of interest you earn in a single day and generally increases the longer the CD is in place.
Differences Between Bonds and Certificates of Deposit
There is a key difference between bonds and certificates of deposit in where investors buy them. Bonds are issued by governments and other entities that wish to borrow money. You typically need a brokerage account to purchase a bond. In contrast, a certificate of deposit can be opened easily. You can set up a CD at almost any bank without major hassle.
How to Decide Between Bonds and Certificates of Deposit
When deciding between bonds and certificates of deposit, you should consider your goals. Do you want a long-term investment that can gain value, or do you just want to keep your money safe for the short to medium term?
Bonds are better suited for long-term investment. The maturity length of bonds can range from one year to 30 years or more and typically offer higher interest rates than CDs. This makes them suitable for long-term investors who want to build a diverse portfolio that can withstand a drop in the stock market.
Certificates of deposit are better for investors looking for a short-term way to keep their money safe. They have lower interest rates than bonds but are virtually risk-free as long as they stay below the FDIC insurance limit of $250,000.
CDs are particularly popular among people saving for goals such as a down payment on a car or a vacation, as CDS make it easy to access funds when needed while simultaneously keeping them safe and earning interest.
The yields on certificates of deposit are almost guaranteed, as they are issued at interest rates set by banks. Additionally, the longer the CD term, the higher the interest rate banks will pay, meaning it will provide a higher return.
If a bond has a fixed rate, that rate will be paid for the entire life of the bond. However, a bond with a variable interest rate will change with the interest rate over time, meaning it can provide high yields when rates are rising and lower yields when rates are falling.
Frequently Asked Questions
How can I compare the yield of a bond to the yield of a certificate of deposit?
To compare the yield of a bond to the yield of a certificate of deposit, you need to ensure you are looking at the right figures.
Before purchasing a bond, you should look at the current yield. This is the bond’s annual interest payments, or yield, divided by the current market value. For example, if the bond pays $50 in interest each year and has a market value of $975, the bond’s current yield is 5.13%.
Before opening a certificate of deposit, you should look at the annual percentage yield (APY). This is the amount you earn from interest, taking into account factors like compound interest. By comparing the current yield of the bond with the APY of the CD, you can accurately compare the yields.
Is a certificate of deposit safer than a treasury bond?
Both certificates of deposit and treasury bonds are subject to other types of risks, such as interest rate risk and inflation risk. The main difference in risk between the two comes when an investor wants to withdraw their money before maturity. With a certificate of deposit, the investor must pay a predetermined penalty for early withdrawal. With a treasury bond, the investor must find another investor willing to buy the bond from them. In theory, there might not be investors ready to buy the bond, while the bank must
Source: https://www.thebalancemoney.com/bonds-vs-cds-5185371
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