As the volatility of returns and rates rattled investors throughout 2022, CDs began to hold broad appeal for many. Bonds can be more risky, as many investors saw in their bond portfolios; in contrast, CDs are insured up to $250,000 by the Federal Deposit Insurance Corp. (FDIC), which makes them stand out for those seeking relative stability.
However, when interest rates have risen and CDs become more attractive, it’s worth asking whether you want to stash your cash or find a potentially more productive way to put it to work.
Although it’s true that CD yields have risen sharply in recent months, it’s worth considering that the potential loss of principal from investing in bonds isn’t the only type of risk involved in trying to generate income from savings. With CDs, there’s the potential that the rates they pay may have peaked—or are about to peak—and could fail to keep up with inflation, which remained relatively high as of early 2023 despite having come down from its mid-2022 peak; in contrast, bond yields adjust with market conditions. As we’ll show below, in the vast majority of instances, mutual funds that hold portfolios of bonds have historically generated greater inflation-adjusted growth than CDs in periods after CD rates have peaked.
How do certificates of deposit work?
CDs are insured deposit accounts that are generally offered by banks or credit unions and offer a fixed annual percentage yield (APY) to investors. The rate of return is higher than savings rates at a bank, yet there’s a trade-off: Money deposited into a CD must stay there for a specific timeframe in order to get the advertised APY rates. For example, these timeframes, or terms, might range from three months to five years.
Over the term of the CD, the issuer pays a guaranteed rate of interest. A consumer might use a CD to generate fixed interest payments on cash holdings that don’t need to be accessed for a while; for example, a prospective homebuyer may deposit cash into a CD to build up savings for a downpayment.
Benefits and drawbacks of certificates of deposit
While CDs’ guaranteed interest payments can be advantageous, they can also present challenges. A fixed APY means the consumer doesn’t see payouts increase when interest rates rise. To prevent consumers from swapping CDs when rates climb, banks may also issue a penalty for early withdrawal of funds that could comprise a few months of interest payments.
CDs may also be callable, which means that a bank can redeem the CD early—paying the consumer back principal and accrued interest—if interest rates fall significantly and the CD’s yield rises above the level that the bank is willing to pay.
Finally, although CDs provide relative safety, so-called real returns may become negative after inflation is factored in. CDs’ potential weakness in this regard is illustrated by the real returns that they generated in six 12-month periods since 1984 that followed peaks in CD rates. After these peaks were reached, CD rates began to decline as the U.S. Federal Reserve (Fed) ended its rate hiking cycles amid easing inflation. However, inflation didn’t go away entirely.
Source: Bankrate.com, Federal Reserve Bank of St. Louis, bls.gov, 2023. Real return of CD is represented by the peak 1-year certificate of deposit (CD) rate minus CPI. The Consumer Price Index (CPI) tracks the average change of prices over time by urban consumers for a market basket of goods and services. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Bond funds and other certificate of deposit alternatives for putting cash to work
Money market funds are among the alternatives to CDs. While these non-bank products are investments that aren’t insured by the FDIC, they offer liquidity—the ability to buy or sell a security quickly and easily. As with other mutual funds, investors can buy or sell money market funds on a daily basis. These funds are limited by securities laws to investing in short-term debt securities with minimal credit risk; they typically hold various instruments such as U.S. government Treasuries and municipal securities that offer short-term liquidity. Unless there’s a major liquidity event, money market funds generally track a daily net asset value of $1.00.
Higher on the investment risk spectrum are bond mutual funds, which don’t face the same limitations as money market funds in terms of the types of bonds that they’re allowed to hold in their portfolios. While the entire fixed-income spectrum encompasses a wide range of risk levels, all bond funds are subject to interest-rate and credit risks. However, with that higher risk level comes greater potential for long-term income generation than CDs and money market funds generally offer.
In fact, in comparing 12-month returns that followed the six peaks in CD rates since 1984, average returns across four Morningstar bond fund categories exceeded the returns from CDs in a large majority of the instances—to be precise, in 20 of the 24 instances studied, or 83% of the time.
Source: Morningstar Direct, bankrate.com, Federal Reserve Bank of St. Louis, bls.gov, 2023. Short-term bond, muni national intermediate, core bond, and core-plus bond represent Morningstar fund category averages. A Morningstar fund category average represents a group of funds with similar investment objectives and strategies, and the category average return is the equal-weighted return of all funds per category. Morningstar places funds in certain categories based on their historical portfolio holdings. Past performance does not guarantee future results.
Another way to compare performance is to show how much $250,000 deposited in CDs grew versus the same amount invested in bond funds during each of those six 12-month periods dating to 1984, as measured by fund category averages.
Source: Morningstar Direct, bankrate.com, 2023. Green shading indicates the 20 of 24 periods when the category average outperformed certificates of deposit (CDs); red indicates 4 instances of CD outperformance. Short-term bond, muni national intermediate, core bond, and core-plus bond represent Morningstar fund category averages. A Morningstar fund category average represents a group of funds with similar investment objectives and strategies, and the category average return is the equal-weighted return of all funds per category. Morningstar places funds in certain categories based on their historical portfolio holdings. Past performance does not guarantee future results.
Comparing certificates of deposit versus bond funds today
While there’s no certainty where inflation, CD rates, and interest rates will go from here, inflation has recently moderated as measured by the U.S. government’s Consumer Price Index, which stood at a 6.4% annual rate as of January 2023, down from a 40-year-high of 9.1% in June 2022. The Fed acknowledged this trend of moderation at its February 1 meeting but lifted its benchmark rate by a quarter percentage point while signaling that it wasn’t finished lifting rates, since it hopes to bring inflation closer to the Fed’s 2% target.
What does it all mean for putting cash to work? Whether you’re looking to get a return on your cash holdings that you’ll need to access in a week, a month, or a year, it’s important to choose the right option for you, and inflation remains a risk that could significantly erode real returns. While CDs offer some advantages over bond funds, it’s worth considering that historical results show bond funds have outperformed in a large majority of instances after CD rates peaked and Fed rate hiking cycles ended.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.