CDs vs. Bonds: Consider the Differences
By Kevin Swanson
With many banks offering 4 – 5% interest rates on certificates of deposit (CDs), many investors are rushing to invest their cash reserves in CDs. Of course, the appeal is understandable, as these are the highest CD rates we’ve seen in almost 15 years. But it’s important to understand the limitations and risks of investing in CDs, as well the potential benefits of other conservative investments, such as bonds.
The allure of CDs: Let’s revisit the 1980s
In the early 1980s, banks offered one-year CDs with rates as high as 18%. I remember this period well, as my mother scrambled to invest every penny she could spare into these high-interest CDs. And who could blame her? People were doing everything possible to stretch a dollar and offset the effects of rising inflation.
What my mother didn’t realize was that interest rates would steadily decline over her one-year term, and that the inflation rate would be at 12% when her CDs matured the next year. So, once her returns were taxed and the inflation rate was factored in, her real returns were actually negative.
CDs have liquidity risk and re-investment risk
Before investing in any product, it’s important to understand potential risks related to inflation, volatility, credit, re-investment, liquidity, prepayment, interest rates, and the markets.
While investing in CDs mitigates certain risks (like volatility, credit, and prepayment risks), it exposes you to others — most notably, liquidity and re-investment risk.
- Liquidity risk: Because you commit to invest for a certain period of time, your money is not available for day-to-day expenses, emergencies, or unforeseen financial circumstances.
- Re-investment risk: CDs expose you to re-investment risk because interest rates may be lower when your CD matures and you have the option to re-invest that money.
My mother’s situation illustrates the negative effects of liquidity and re-investment risk with CDs. She invested at peak interest rates and enjoyed the high returns, but didn’t have access to her money as the effects of inflation set in. Interest rates declined over the 12-month term, so when her CDs matured in late 1981, she didn’t have feasible re-investment options. And her positive returns were reduced by taxes, as interest is taxed as ordinary income.
In today’s high interest rate market, re-investment risk is also high. For example, if you invest in a one-year CD with a 5% interest rate, rates are likely to be lower when your CD matures next year, limiting your re-investment options.
Bonds offer liquidity and potential capital appreciation
An alternative to investing your cash in CDs is to build a portfolio of bonds, bond funds, and Treasuries. Currently, diversified bond portfolios are yielding 4 – 5%, similar to current CD rates. And as long as interest rates remain stable or decline, these yields should continue.
Unlike CDs, bonds offer liquidity and the potential for capital appreciation:
- High liquidity: Most bonds can be sold and converted into cash within a week, without penalty. In contrast, CDs lock your money in for a certain period.
- Potential for capital appreciation: If interest rates decline, which we anticipate over the coming months, bond investors can benefit from capital appreciation, in addition to the yields. For example, if you own a bond that appreciates in value, you could sell it for more than you paid.
Managing a bond portfolio does introduce interest rate risk — meaning, as interest rates rise, bond prices fall. But we believe this risk is currently low, given the Federal Reserve’s recent indication that they are nearing the end of this rate-hike cycle.
And when it comes to understanding how bonds are taxed, there are various factors to consider, such as the issuer, the type (e.g., bond funds, individual bonds, Treasuries), whether you purchased it at a discount, whether you sold it or simply earned interest, and more. So, while bond interest may be taxed as ordinary income, which is the same as CDs, certain government and municipal bonds offer investors tax breaks.
Deciding how best to invest your cash
The first step in determining the most suitable investment strategy for your cash is to have a conversation with your financial advisor. By clearly communicating your investment goals and timeline, your advisor can assess your unique objectives and identify the risks that are relevant to your situation.
At Potentia Wealth, we are committed to partnering with clients to help them make informed investment decisions. If you’d like to discuss your specific situation, we’d welcome the opportunity to meet together and help you determine next steps.
The content is developed from sources believed to be providing accurate information. Potentia and Potentia Wealth do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation.
Investment advice offered through Mariner Independent Advisor Network, a registered investment advisor. Mariner Independent Advisor Network, Potentia Wealth, and Potentia are separate entities.
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