Bonds are debt instruments issued by corporations and governments; certificates of deposit (CDs) are federally-insured bank products. Neither bonds nor CDs are particularly good vehicles for long-term savings because of their relatively low historical returns vs. other assets such as stocks or real estate, but their relative safety makes them appropriate for use in balanced portfolios to counterbalance stock risks with safety and stability. The similarities between bonds and CDs make them interchangeable in some situations; the differences between them make specific bonds or CDs more or less appropriate for specific situations.
Safety vs. Income
CDs are federally-insured and are virtually risk-free; bond risks vary based on the issuer's credit: U.S. Treasury bonds are very safe because their interest and principal are backed by the full faith and credit of the U.S. Government; corporate and municipal bonds have varying degrees of safety based on their credit ratings. The safer an instrument, the less interest it pays. A CD investor does not risk his principal but will earn less interest; a bond investor can balance the amount of interest he wants to earn against the amount of risk he is willing to take.
Capital Gains and Losses
CDs do not trade in the secondary market: a CD investor can buy a CD and hold it to maturity or, if he needs the money, surrender it by forfeiting some interest, but he will not lose principal. Bonds trade in the secondary market for more or less than their face value - the contractual amount to be repaid at maturity -- that is, at a premium or at a discount. An investor who buys a bond at a premium and holds it to maturity will have a capital loss; an investor who buys a bond at a discount and holds it to maturity will have a capital gain.
Both CD and bond interest rates depend on the general level of interest rates, which typically move in cycles. If an investor uses CDs or short-term bonds, the amount of interest he earns will fluctuate with the changing interest rates. If interest rates drop, even if an investor has locked in a good rate in a long-term bond, he will have to reinvest the interest at a lower rate, earning less than the original investment.
Investors can buy bonds with maturities ranging from 1 to 30 years; CDs generally have maturities from 1 month to several years. The wide range of maturities gives investors flexibility in addressing their long-term savings needs. For example: If interest rates are high, an investor can lock in a good rate for 20 or 30 years in a long-term bond; if interest rates are low, an investor can stay liquid by keeping his money in short-term CDs or bonds.
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