I have briefly attempted to summarize some of the key differences and similarities between CDs and Treasuries, as well as how those differences play out in portfolio construction.
This is a very lazy first stab at things, and I am sure I have missed key points, as well as thoroughly offended one camp or another . Let's discuss this here, and then I or someone else can update the wiki ( http://www.bogleheads.org/wiki/CDs_vs_Bonds ) with our findings.While CDs are often thought of as different assets than bonds, in reality they are simply bonds with special characteristics. These differences and similarities will be explored below.
Because CDs, like U.S. Treasuries, are backed by the full-faith and credit of the U.S. Government, Treasury Bonds are the appropriate comparison. Furthermore, because there is no functional difference in the behavior of a rolling bond ladder and a bond fund,in the interests of brevity, in the interests of brevity, the term "bond" on this page can be taken to mean U.S. Treasury bonds or Treasury bond fund.
Characteristics and Risks
In general, assuming yields are equal, CDs are preferred to bonds in rising-interest-rate environments, whereas Treasuries are preferred to CDs in falling-rate environments.
* Liquidity - Treasuries are the most liquid bond market in the world. CDs, by contrast, cannot typically be traded; even brokered CDs have fairly high spreads. In a rising rate environment, this lack of liquidity is not a problem if the CD has a put option (see below). In a falling rate environment, however, liquidating the bond for purposes such as rebalancing, tax management, or funding unexpected life events, becomes costly (at risk is exactly equivalent to the increase in market value of a bond in a falling rate environment).
* Options - Many CDs have a put option which allows the bondholder to receive the premium back from the bank in exchange for a penalty (typically 3-6 months of coupon payments). In a rising rate environment this can be a valuable feature of CDs. Treasuries no longer have embedded call options, and CDs do not have call options. However, CDs are subject to a certain type of call risk--the risk that if a bank goes under, the FDIC will not continue to honor the terms of the original bond agreements. The amount at risk is exactly equivalent to the increase in market value of a bond in a falling rate environment.
* Purchasing convenience - Some individuals prefer dealing directly with their local bank; others prefer dealing with a broker of their choice.
* Credit risk - Both CDs and Treasuries are obligations of the U.S. Government, and are therefore considered to have no credit risk. CDs must remain under certain purchase limits to maintain this feature.
Because CDs cater primarily to the individual investor market, whereas Treasuries can be traded in large volumes by institutional investors as well, and because the characteristics of the bonds differ (particularly with regards to liquidity and options), yields on Treasuries and on CDs are never exactly alike.
Also, I have long been curious about the historical market rate differences between the CD and Treasury yield curves. Treasury's easier to find, but CDs much less so (not least because there's no one rate for CDs, only an average and a min/max). Does anyone have that info?