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, 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 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 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.  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.

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:

