CDs vs Government Bonds: Which is Better?
CDs and government savings bonds are said to be some of the basic building blocks in a typical investment portfolio. But if an individual only has resources for one investment alternative at any given time, which is the better option?
CDs and Government Bonds Defined
Certificates of Deposits or CDs are a type of short to medium-term investment products available in banks and savings associations wherein a depositor agrees to deposit his money for an agreed specified period of time, and for a higher interest rate.
Government bonds on the other hand, are debt securities issued by the federal government through the US Treasury. This means that when you buy government bonds, the federal government owes you. A bond typically comes with a coupon for interest payment at a specified interval.
There are different types of government bonds that are available for potential investors. Briefly, the most common types of government bonds in use today are:
Treasury Bills (T-Bills)
T-bills have terms of one year or less. Investors are not paid interest for T-bills and instead, buy them at a discount of the face value, which is paid out at maturity, thus the yield from the principal investment.
Treasury Notes (T-Notes)
T-notes have terms of 2 to 10 years with interest paid every 6 months.
Treasury Bonds (T-Bonds)
T-bonds have the longest maturities stretching from 10 to 30 years. Like T-notes, coupon payment for T-Bonds is made every 6 months.
Treasury Inflation-Protected Securities (TIPS)
Offered since 1997 and with 5-year, 10-year, or 20-year maturities, TIPS are inflation-indexed securities. This basically means that the principal is adjusted according to the Consumer Price Index, which is commonly used to measure inflation, on a semiannual basis. The coupon rate is then paid on the adjusted principal.
Series I Bonds
Among the most popular bonds available, I bonds are sold at face value and have 2 interest rate components: a fixed rate which will be applied over the life of the bond, and an inflation-adjusted rate which is reset semi-annually, in May and November.
Series EE Bonds
Series EE Bonds are offered at 50% of face value. Interest is paid to the account monthly and with fixed rates set every May and November. While they are designed to reach their face value on the 17th year, an investor can hold it to mature in 30 years while continuing to accrue interest.
So how do government bonds stack up against the traditional CD? Here are the main features a prospective investor would look for in an investment option, and how the two alternatives compare against each other in every category, keeping in mind the variety of government bonds in the market today.
Both are considered to be two of the safest investment vehicles at this time. Government bonds are backed by the “full faith and credit of the United States Government”, and the CD is insured up to $250,000 by the FDIC.
CDs currently have daily averages of 1.85%, 2.16%, and 2.19% APY for 12, 24, and 36 months respectively. For savings bonds issued between November 2008 and April 2009, the effective interest rates are 5.64% for the Series I, and 1.30% for the Series EE. Series EE Bonds issued from May 1997 to April 2005, now earn 2.80% as of the latest repricing last November 2008.
Government bonds hold a distinct advantage over CDs when it comes to taxes. Unlike the CD, bonds are exempt both from local and state taxes and are only levied at the federal level. What’s more, if the interest from a Series EE or Series I Bonds is to be used for education purposes, it’s completely tax-free.
Terms and Liquidity Premium
CD terms usually go from 3 months to 60 months. Depending on the type of treasury or savings bond, maturities can be as short as 28 days (T-bills) up to 30 years.
Whether an investor holds his CD or bond to maturity is also an important factor in deciding which alternative to take. Withdrawing a CD before maturity can have you pay significant interest penalties. For the savings bonds, Series EE and Series I, you can’t cash in on these until you’ve owned them for a year, and if you do so before 5 years, the penalty is worth 3 months of interest.
CDs can be purchased for a minimum of $500 with practically no limit. To ensure FDIC coverage, divide your CDs in different banks if you have more than $250k stashed away.
Treasury securities (T-bills, T-notes, T-bonds, TIPS) can be bought for a minimum of $1,000 and a maximum of $5 million per auction. Savings bonds can be purchased for as low $25 but with a limit of $10,000 ($5,000 in paper bonds and $5,000 through Treasury Direct) per year per Social Security Number.
Choosing to invest in CDs or any government savings bonds will depend largely on present needs and future plans. CDs are relatively easier to compute and monitor especially if you opt to have it automatically renewed. Savings bonds can give you higher returns and keep you protected from inflation but you have to be prepared to keep it in for at least a few years.