Certificates of deposit and bonds are two very popular forms of fixed-income investing. Both offer a pre-determined stream of income and a return of principal. Despite their similarities, there are significant differences between the two investment options, both in the structure of the investment and the associated risks.
Basics-Certificates of Deposit
Certificates of deposit are typically issued by banks, savings and loans, credit unions and other financial institutions. In exchange for lending a fixed amount of money for a fixed period to the bank or financial institution, the investor receives a stream of interest payments from the bank and the return of the investment at the maturity of the certificate of deposit. Certificates of deposit are generally considered safe investments and, as a result, pay a relatively low rate of interest compared to many bonds.
In the United States, the Federal Deposit Insurance Corporation (FDIC) provides the option of insurance protection for qualified deposit accounts at member banks. This insurance protection extends to $250,000 per depositor, per insured bank. Certificates of deposit are included in FDIC-insured investments. The risk of loss on an FDIC-insured account is generally considered to be extremely low. FDIC insurance protection is not available for investments in bonds.
Bonds are fixed-income debt with a set maturity issued by businesses, governments and governmental entities to provide financing for various projects and operations. Since many of the funded projects may be long-term, it is generally easier to find longer-term bonds than it is to find longer-term certificates of deposit. Bonds pay a pre-determined rate of interest and offer the return of the principal, or face value, at the maturity of the bond.
Many bonds are frequently traded on investment exchanges. This makes the bonds liquid, which means that investors can purchase or sell bonds at market prices at any given time. The same is not true for certificates of deposits. To "cash out" a certificate of deposit prior to maturity, an investor typically incurs a large penalty. In addition, the rate of return offered by many bonds is significantly higher than those offered by certificates of deposit. This is because bonds are much riskier. Companies and governments can, and do, default, meaning bondholders lose much of the value of their holdings. U.S. Treasury bonds, however, are generally considered risk-free and are as secure as FDIC-insured certificates of deposit.
The taxation of bonds and certificates of deposit differs as well. In the United States, interest paid upon certificates of deposit is taxed at ordinary income rates, which are amongst the highest rates paid by individual income tax payers. While bond interest is taxed at the same ordinary income rates, the appreciation or depreciation in the price of a bond may be eligible to be taxed at capital-gains rates, which may be significantly less than ordinary income rates. In addition, the interest on many government bonds may be free of state or federal income tax.