CDs vs bonds

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 (when purchased properly), 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, the term "bond" on this page is simplified to mean either U.S. Treasury bonds or Treasury bond fund.

The following primarily applies to un-brokered CDs of greater than 1 year maturity, with no particularly exotic options (e.g. a simple coupon-paying CD with no call option). As this is by far the most common type of CD, and is what most people mean when they say "CD," this will allow the analysis to be simple yet relevant.

Characteristics and Risks
In general, assuming yields are equal, CDs perform better if interest rates rise (because of their put option), whereas Treasuries are preferred if interest rates fall (since their liquidity means you do not have to wait until maturity to profit from the rate change). However, as noted below, CDs seem to yield more than Treasuries in most market environments for the reasons discussed there.


 * 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 CD 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 investor to receive the deposit back from the bank in exchange for a penalty (typically 3-6 months of interest payments). In a rising rate environment this can be a valuable feature of CDs since it allows the investor to invest in a new higher yielding CD.  Be certain that any put option is a contractual agreement at the sole discretion of the bondholder in the Truth in Savings disclosure; vague suggestions not embodied in the contract on this point are apparently common.  Often CDs have a "death put" that can be useful in estate planning.  Treasuries no longer have embedded call options, and CDs do not have call options, so if interest rates decline the investor can continue to hold the higher yielding note or CD to maturity.  However, CDs are subject to a certain type of call risk--the risk that if a bank  fails  the FDIC might not continue to honor the terms of the original CD agreements, especially if the CD offered premium rates.  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 when buying a CD; others prefer dealing with a broker of their choice. Another consideration in convenience is that CD yields vary widely depending on the issuer, and time must be spent locating the highest yield (and switching between institutions to seek out the highest yield). Treasuries can be bought at auction, often at zero cost, from a bank, brokerage account, or Treasury Direct. The treasury investor faces transaction costs if the security is sold on the market prior to maturity; the CD investor faces early withdrawal penalties for cashing in the CD prior to maturity.


 * 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.


 * Taxation - Treasury bills and notes are exempt from state taxation; CD's are subject to both federal and state taxation.

Market History
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 taxation, liquidity and options), yields on Treasuries and on CDs are never exactly alike.

Market data for CDs can be difficult to come by, because for the individual investor a little time searching can often yield above-average rates in the CD rate. Nevertheless, the data presented below is likely a good first approximation of the historical behavior of the two bond categories, at least for ultra-short maturities. Longer issues may behave much differently, because the options and liquidity differences become more pronounced over longer holding periods.

Graph of CD vs. Treasury yield over several decades, source: Federal Reserve Bank of St. Louis - consider data source against above statement about interest rate characteristics. All available data:

Same data, but from 1977:

