There is a fair amount of overlap between certificates of deposit (CDs) and bonds — they are both fixed-income securities which you generally hold on to until maturity. Simply put, you put your money into a CD or bond for a set period, and you know exactly what you will receive when that time is up.
They are both debt-based, meaning that you are the creditor — no different than having a friend ask for 10 dollars today and give you an IOU promising to pay 11 dollars tomorrow. The interest (one dollar) is collected for the same reason that banks charge interest on loans: to compensate for delaying the ability to spend money. Loaning out 10 dollars deprives you of having that 10 dollars to use now for whatever you wish.
How Bonds and CDs are Different
We now know why bonds and CDs fit under the same broad category, but here is how they differ:
1. The Issuer
In the case of bonds, the issuer is usually a company trying to raise funds for operations, the development of new products or the opportunity to take over another company. Investment-grade bonds have a very low default risk (the chance that your friend will take your 10 dollars and never come back), but it can definitely happen.
The issuer of CDs is usually a bank because CDs are not issued with the same motives that underlie bonds. CDs are similar to a savings account — basically a place to hold your money until you want to do something else with it. Because bonds issued by a company are riskier, they offer a more favorable return to the people who buy them. The return on CDs, however, is typically less than bonds but a little better than a savings account.
2. Time to Maturity
This is the sticky part, but also the most significant point. Bonds are longer-term investments, generally maturing in more than 10 years. By contrast, CDs mature in as little as one month and as much as five years. The complication we run into now is that there are further distinctions or categories within the world of fixed-income debt securities, and they overlap everywhere.
The loose categorization is as follows (put an imaginary "generally" in front of each description):
- T-Bills - mature in less than one year
- Notes - mature between one and 10 years
- Bonds - mature after a decade or more
In other words, while a bond is technically a fixed-income security with a maturity of more than 10 years, people often use the term "bond" to refer to fixed-income securities in general — even those securities with a maturity of less than 10 years.
The difference in time commitment for bonds and CDs is best expressed in terms of the investor's motives. As previously mentioned, CDs are generally considered short-term, low-risk, interest-paying storage for capital until a more profitable investment can be found. Bonds are considered long-term vehicles for guaranteeing a profit and, perhaps, offsetting some of the risk an investor may face in higher-yield investments such as equities.
(For more on the subtle differences between bonds and CDs, check out our Bond Basics Tutorial.)
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