CDs vs. Bond Funds: Which Is Better?

BY Paul Solman  December 14, 2012 at 11:00 AM EDT

Photo by Peter Dazeley via Getty Images.

Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page. Here is Friday’s query:

Paul Hyland: Please discuss the merits of one- or two-year CDs versus low-cost bond funds. I’m afraid rising interest rates will decrease even bond fund asset values. Thank you, Paul.

Paul Solman: You’re welcome, Paul. Look, the principle is simple and forever the same: the longer you lock up your money, the more vulnerable you are to interest rate change. That’s why interest rates tend to be higher, the longer the maturity (duration) of an investment. It’s because of the higher odds that inflation will occur between the time you loaned someone your money and the time you get it back. The higher interest rate is meant to compensate you for the risk that the amount owed to you will lose value in the interim.

A one- or two-year CD (certificate of deposit) is simply a loan that locks up your money for either one or two years. You forego the interest if you withdraw the money beforehand, a penalty for breaking the lock-up agreement.

A bond fund, by contrast, is a pool of loans of which you buy a share. If the loans are municipal bonds, it’s a municipal bond fund. A government bond fund invests in treasuries; a corporate bond fund, in bonds issued by corporations, aka “commercial paper.” And so on.

How to compare the interest rate risk of a CD with that of a bond fund? It all depends on the average “maturity” of the bonds in the fund; again, for how long are you tying up your money? In the case of a fund, there’s no penalty for early withdrawal. Instead, the value of your share in the fund drops if interest rates rise before the bonds come due.

The logic is counter intuitive, but essential if you’re going to invest in bonds, and understand what you’re doing.

If you buy a one-year CD, you’re taking little risk. How much are interest rates likely to spike in just one year? After the year is up, you collect your interest, get back your principle, and you can reinvest at the new, higher rate.

A fund which owns bonds that all mature in one year would be no different, except that you’d pay a management fee, a fee deducted from your total return.

But most bond funds own bonds of varying maturities. So you have to research the fund and find out what its average maturity is. That’s the way to tell if you’re investing in bonds that won’t be paid back for a while, and are thus more vulnerable to interest rate spikes, and bonds for money lent short-term, which are less vulnerable.

This entry is cross-posted on the Rundown — NewsHour’s blog of news and insight.