Bond funds and certificates of deposit work similarly in that both investments generate income. Bondholders and CD account holders are creditors who lend money to businesses, governments or banks, in return for interest payments. However, while bond funds and CDs have many similarities, these two investment types differ in major ways.
When you buy a CD, you give your money to a particular financial institution. While you can buy bonds through investment brokers, most CD investments involve just two parties: you and the CD issuer. When you buy a bond fund, you invest in a fund that contains a wide variety of bonds issued by different entities. A fund manager controls the fund and can buy and sell bonds on a regular basis. With a CD, your investment returns depend on the financial health of one institution. When you buy a bond fund, you diversify your holdings, and you do not lose all of your money if one bond issuer goes bankrupt.
As a shareholder in a bond fund, you have an ownership stake in a portfolio of debt securities. However, bond funds are typically open-ended investments, which means that you can buy or sell shares at any time. The fund regains control of your portion of the fund if you decide to redeem your shares. When you buy a CD, you agree to keep your money on deposit at a financial institution for a set number of months or years. You cannot sell your CD to someone else and if you redeem your CD early, you usually have to pay a penalty fee. Penalty fees can reduce both your principal and interest. Therefore, bond funds provide you with greater liquidity than CDs.
When you buy a CD, you sign a time deposit agreement and based upon the terms of that agreement, you normally receive a fixed rate of return. Some CDs have variable rates, but the CD contract includes details of your minimum and maximum possible returns. When you buy a bond fund, you receive dividends rather than interest payments, but the fund manager funds the dividends with interest payments on the bonds contained within the fund. The dividend payment can change at any time if bond issuers default on payments or if bonds mature and the fund manager replaces the bonds with new lower-yielding bonds. Therefore, CDs offer fixed returns while the returns on bond funds can fluctuate.
CDs issued by banks and credit unions do not fluctuate in value.You could lose money if the CD issuer goes bankrupt, but federal agencies insure CDs up to $250,000 per account holder per financial institution. Thus, your principal is generally safe.
The value of shares in a bond fund can fluctuate on a daily basis. Bond holders can buy and sell bonds on the open market, and mid-term bonds can sell for a premium or at a discount price depending on the market conditions. Short-term bonds experience less volatility than long-term bonds but bond funds do not provide you with the principal protection that you enjoy with CDs. CDs, on the other hand, do not provide you with the potential for price appreciation, while bond funds can grow in value.