Quora Answer: Are Bonds Better Than Certificates of Deposit?

The following is my answer to a Quora question: “Which is better: bonds, or certificates of deposit?” 

A bond is a fixed income instrument, a debt security, representing a loan made by an investor to a borrower.  That borrower is typically a corporate or governmental entity.  A bond has a specific end date, when the principal of the loan is due to the investor, the bond owner.  The terms of the bond includes the terms for variable or fixed interest payments, that will be made by the borrower to the investor. 

A certificate of deposit (CD), on the other hand, is a savings certificate, with a fixed maturity date and fixed interest rate.  A CD is illiquid since it restricts access to the funds until the maturity of the investment.  CDs are generally issued by banks.  Since the CD is a promissory note, it is also a debt instrument, like bonds.  However, they are different in several ways.  Bonds tend to give a lower rate of return, unless they are unrated.  CDs tend to give a higher return, but at the cost of liquidity.  This means that when there is a change in the market, you can easily transition your portfolio weightage from debt to equity to take advantage.  You cannot do that with CDs without substantial losses since the funds are locked in until maturity. 

Bonds have a longer repayment period than CDs.  Unlike CDs, which may be up to 4 years, in most cases, a bond can have a maturity of up to 30 years, in the case of Treasury bonds.  That means holding a bond to maturity to extract yield is not viable if that is the only thing you have on your portfolio.  Your earnings are likely to be below the rate of inflation.  Bonds are also more volatile because there is a secondary market for them due to their liquidity.  There is no such secondary market for CDs since they are not traded on any exchange. 

As can be seen, one is not necessarily better than the other because they serve different purposes.  People put bonds on their portfolio to balance the inherent volatility of stock and equity instruments.  But they are liquid enough that you can adjust the weightage of a portfolio as required. 

CDs are a means to lock in funds that are not currently needed for a period of time to earn something.  They balance currency risk, and they are insured to the limit allowed by law since the funds essentially lent to the bank.  In the US, the FDIC limit is $250,000 per account owner.  You can borrow against a CD if it is substantial enough, such as through a credit line, but that is not ideal.  CDs are also used to balance portfolios, but over an extended investment horizon.  While investors require cash instruments, having all of it on hand exposes them to currency risk.  CDs are a way to safeguard that for a period of time where the funds are not foreseen to be needed.