CD vs Bond Fund: A Case Study


After reading my previous post Diversify Bond Funds with CDs, reader Matt emailed saying

“It sounds good but my bond fund returned 6%+ a year in the last few years. If I had bought CDs instead, I would’ve missed all the good returns. I don’t think CDs were yielding 6% when I bought my bond fund.”

Before I break out the standard statement about past performance, I’d like to do a case study. What if you bought a CD instead of a bond fund say in 2009?

Vanguard shows that back in January 2009, Vanguard Total Bond Market Index Fund Admiral Shares had a SEC yield of 4.36%. Google shows that a 7-year CD from PenFed was at 4.5% APY at that time. A 7-year CD had a slightly higher yield than the Vanguard Total Bond Market Index Fund back then.

Investors who bought the bond fund and the CD had these returns in the next four years:

Bond Fund CD
2009 6.04% 4.5%
2010 6.54% 4.5%
2011 7.69% 4.5%
2012 4.15% 4.5%
2009 – 2012 average 6.1% 4.5%

Matt is correct: in those four years he received a better return in his bond fund than he would have in CDs. Because interest rates dropped, the bond fund had a boost from capital gains.

But wait, it ain’t over yet. The bond fund is yielding less now. The CD is still paying 4.5%. The higher return in the bond fund in the early years came at the cost of lower returns in the future. This is very similar to funding one’s expenses by debt. Today’s joy comes at the cost of tomorrow’s pain. Over the full course of 7 years until the CD matures, here’s what the returns looked like (updated in 2016 with 2013-2015 returns):

Bond Fund CD
2009 6.04% 4.5%
2010 6.54% 4.5%
2011 7.69% 4.5%
2012 4.15% 4.5%
2013 -2.15% 4.5%
2014 5.89% 4.5%
2015 0.40% 4.5%
2009 – 2015 average 4.0% 4.5%

A 7-year CD bought in 2009 did better over its full 7-year life after all, even though the interest rate dropping nearly 3% in the first four years was very favorable to the bond fund. The returns from the CD are more even. You don’t feast today and starve tomorrow. You don’t worry about any purported bond bubble. You just collect interest and reinvest at the original yield, even and steady.

That was then. What about now? The Vanguard Total Bond Market Index Fund Admiral Shares has an SEC yield of 2.1%. A 5-year CD from Synchrony Bank pays 2.25% APY. Forget about the option to take an early withdrawal if interest rates go up. If you just stick to it for 5 years, I would say you will end up with more money if you invest in the 5-year CD instead of the bond fund.

Interest rate can’t drop another 3% in the next four years when it’s already at 2.1%. If a very favorable interest rate environment couldn’t push the bond fund to win over a CD bought at the same time, a less favorable environment won’t be able to do it for the bond fund today either.

[Photo credit: Flickr user smcgee]

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  1. TJ says

    “What about now? The Vanguard Total Bond Market Index Fund Admiral Shares has an SEC yield of 1.6%. A 7-year CD from Discover Bank pays 1.9% APY. Forget about the option to take an early withdrawal if interest rates go up. If you just stick to it for 7 years, I would say you will end up with more money if you invest in the 7-year CD instead of the bond fund. ”

    That will be incredibly depressing if true. I highly doubt the CD beats the bond fund after the next 7 years.

  2. foss says

    I would prefer the analysis of a 2009 Treasury (exact same credit risk) purchased at the same time as the CD.

    I’ve always been confused on the ‘duration’ of a CD, but a 2009 7yr to maturity Treasury vs a 7 yr Penfed CD is a much closer comparison.

    I don’t know the results of such a comparison, but that is what should be examined, especially in light of the fact that the 7 yr CD has a decreasing tme to maturity but the bond fund has a constant maturity (relatively) and duration. Of course a shorter duration bond fund right now would yield almost nothing…

    In analyses like this, it is best to compare two fixed income instruments of equal credit and term risk. That’s not happening in the above example. Finally, I agree it is highly unlikely that rates drop even more, but if they do, then the 1.6%/yr estimate is wrong. Likewise the other way round, of course.

  3. foss says

    on 1/2/2009 the 7 yr treasury was yielding 2.07%.
    the 10yr was at 2.46%.

    at then end of 2012 it was 1.18 and 1.78% for those respectively.

    I can’t do the fancy math right now, but I’d be interested to see how the numbers look for 2009-2012, and then with assumptions going forward.

    for the record, I loaded up on 10-12yr 5% CDs in a 529 in 2009-10 🙂

  4. Harry says

    foss – I just did the fancy math. I gave the 7-year Treasury note a 2.125% coupon. With the yield dropping from 2.07% to 1.18%, the value of a $10,000 investment rose to $10,277 on 1/2/2013. During the four years, it received $850 in interest. Altogether, if the investor sold the Treasury note on 1/2/2013, the compound average rate of return would have been 2.6% per year, higher than the 2.07% yield or the 2.125% coupon due to capital gains from fallen interest rate.

    Meanwhile $10,000 in the 7-year CD at 4.5% APY received $1,800 in interest in four years. Forfeiting one year worth of interest by breaking it early on 1/2/2013 would’ve left the investor with $1,350 in interest. Altogether the compound average rate of return would’ve been 3.2%, lower than the 4.5% rate due to early withdrawal penalty, but still higher than the return from 7-year Treasury.

    Holding the CD and the Treasury for another 3 years to maturity will obviously see the CD win hands down when the principal value for both return to $10,000 and the CD will pay more than twice in interest.

    I gave several advantages to the bond fund in the article. A relatively constant maturity and duration benefits the bond fund in a declining interest rate environment. Holding less credit worthy mortgage and corporate bonds also benefits the bond fund. Even with these advantages, the bond fund can’t beat the CD over a full 7-year cycle.

  5. TJ says

    “Even with these advantages, the bond fund can’t beat the CD over a full 7-year cycle.”

    Doesn’t that depend on how much interest rates go up by?

  6. Harry says

    TJ – No, it will make it worse. With only 3 years until the CD matures and a duration of 5.x years for the bond fund, any 1% increase in interest rates will bring down the NAV of the bond fund by 5% but only give 1% extra per year for maximum 3 years. If interest rates don’t start increasing for another year, you have only 2 years to go instead of 3. Either way there isn’t enough time to make up for the 5% NAV loss.

    For the bond fund to have a chance to beat the CD, interest rates have to hold constant for another 2 years, then go down from 1.6% to 0.6% in year 3, producing a capital gain again. Not a good bet IMHO.

  7. Foss says

    Thanks for the fancy math.

    I own (and have sold) lots of individual TIPS. I hold anintermediate term treasury fund. It has done well since when I bought it in 2006, but no question, a CD at 4.5% would have a better result both risk adjusted and cagr. Done deal. Thanks for doing the heavy lifting.

  8. Harry says

    TJ – Institution investors don’t have a choice. I have a few theories for why retail investors don’t realize CDs are a better deal. I will write them in a new article.

  9. Henry says

    Aren’t there times when bonds have higher yields than CD’s?

    Realize that right now that isn’t the case, though.

    Looking forward to your new article!

  10. foss says

    I wrote a longish post on this and then sadly it didn;t show up – might have been ipad related

    in reply to #8, TJ here are the issues as I see them

    1.) retail investors vs institutions – institutions with billions need deep liquid markets. CDs are not that. Right now, retail investors get a relative free lunch bc of the glut of $ with no place to go safely. Also, CDs are less liquid, so you do pay a little for that. This btw, is the same, to some degree, as the I-bond vs TIPS issue.
    2.) location problem. I have a bunch of fixed income in tax deferred accts (especially my 401k plan). I don’t have access to good CD rates in those (fidelity brokered is all I can do). I could sell the treaury bond fund I have there and then buy fixed income outside of tax deferred space or in a new IRA (eg at Penfed). Ecept that rquires new $, or the sale of taxable equities to make that shift, with the attendant tax consequences. Not ideal and not ‘easy.’
    3.) Inertia. Basically the same as #2. For all of that work I ‘might’ get an improved $1000-$2000/yr in return, no guarantees on that either. And yes, I would lose liquidity etc.
    4.) Recent talk about changes in the T&C for CDs and early breakage penalties/restrictions (much ado about nothing but may factor in).

    For now, I’ve slowly sold TIPS in deferred space and replaced with I-bonds when I get new money to invest, but that’s the best I can do…

  11. Nervous Cat says

    7 year CD? I’ve never liked the idea of locking up money that long. Then again, maybe I should have bought a longer term CD in 2007. Mine was a two year CD that got decent interest (just over 4%) but when it matured, I renewed to a 1 year CD and just kept renewing while watching the interest rate drop. I didn’t renew the CD last year and put the money into The Vanguard Total Bond Market ETF and PIMCO Total Return ETF. I’ve probably been investing in CDs the wrong way for a long time, but I use CDs as my emergency fund so I like shorter durations.

  12. foss says


    most CDs can be broken early ( with penalties)
    there are extensive articles/sites on the breakeven periods for when you can break a CD, pay the penalty and still come out ahead of other similar credit risk instruments (eg nominal treasuries)

    in most cases, assuming that you can break the CD early (hassle factor notwithstanding) you come out ahead with the CD

  13. Steve says

    Think this article is right on target. I’ve always avoided bonds (with the exception of I bonds that can be cashed out with minimum penalty if rates rise) over CDs. The last several decades while bond yields dropped (making the bond increase in value over its original issue) would have been the best possible environment for bonds. Yet today with rates at near zilch, there is only one way bond rates can go—up. And every uptick erodes the value of the bond. The case for buying CDs over bonds seems very clear to me. Guaranteed interest rates that beat bonds, 100% security, and the possibility of easily cashing out early and reinvesting at a higher rate should rates suddenly skyrocket. Bonds- not guaranteed, value changes if sold early (with the current low rates the bet is on them loosing value as rates rise), and subpar interest compared to CDs of similar maturity.

    I’ve been investing for 40 years. Remember the days when you could get CDs at 14-16 percent. Have always used CDs for my “bond” side of the portfolio, instead of bonds- with the exception of I bonds which guarantee me keeping up with inflation. Have seen pros recommend otherwise- saying one must buy bonds for stability of the portfolio. Still have never figured out why when you look at the numbers and safety. CDs serve that role better.

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