Most investors add bonds and certificate of deposits (CDs) to their investment portfolios. Although both investments pay interest on the principal amount invested, there are some major differences between the two assets. Investors contemplating purchasing these assets must understand how they work and the advantages and disadvantages of added them to their investment portfolios.
Investing in Bonds
Investors can choose from several types of bonds. The most common types include treasury, municipal and corporate bonds. When you buy a bond, you lend your money to the corporation or agency issuing the bond. Similar to a CD, you are paid a fixed rate of interest on the bond until maturity. However, unlike a CD, the bond is not insured, so there is a risk of losing your principal. The corporation or agency agrees to make interest payments to you as specified when you purchase the bond. You may receive interest payments quarterly, semi-annually or once a year. At the end of maturity, you receive your principal back.
Bond Investing Pros and Cons
The advantage of investing in bonds is that you receive fixed income. Although interest rates fluctuate, interest payments are called fixed income because you are guaranteed these payments for the life of the bond. Another advantage of bond investing is that bonds are less risky than some other assets and provide a better return than CDs. Treasury bonds are relatively safe investments and municipal bonds provides tax advantages to investors. The disadvantage of bond investing is that the possibility exists that a company can go bankrupt, causing you to lose your principal. Another disadvantage of investing in bonds is that if you purchase a bond offering a low interest rate and then interest rates increase in the future, your money is usually tied up in that bond until maturity.
Investing In a CD
CDs offer investors a guaranteed rate of return on their investment with little risks. When you purchase a CD, you invest an agreed upon amount as the principal and receive a fixed rate of interest. Currently, some CDs offer investors higher variable interest rates. The lengths of CDs vary, and can include an investment of six months, one year, five years or ten years. At the end of the investment term, you receive your principal and interest accrued on the investment. Investors can purchase CDs at their local banks, credit unions and some brokerage firms. The Federal Deposit Insurance Corporation (FDIC) insures CDs up to $250,000. This means that if the bank goes out business, the FDIC protects your investment as long as it’s $250,000 or less.
Pros and Cons of CD Investing
The main advantage of investing in CDs is that your principal is protected and you receive a guaranteed interest rate. This is especially important when the financial markets suffer and stocks and bonds experience prolonged volatility. Another advantage is the ability to earn interest on your investment in a short time period. A disadvantage of investing in CDs is that you may experience a difficult time withdrawing your money before the maturity date; you may also incur penaltes. Inflation rates affect CD interest rates. If your money is tied up in a CD during inflationary periods, you may lose purchasing power.