Why Investors Don’t Realize CDs Are a Better Deal Than Bonds

Thinker Close Up

After reading my article last week CD vs Bond Fund: A Case Study, reader TJ asked:

“Why does anyone hold bonds EVER, if CD’s always win?”

First, like many things in life, it’s not all-or-nothing: all bonds no CDs or all CDs no bonds. Even if CDs are strictly better than bonds, there are still reasons to hold bonds instead of CDs.

CDs are typically not available in 401k or 403b plans. If we have another stock market crash, it’s easier to sell bonds to buy stocks for rebalancing. But as I wrote in the previous article which debunked a few myths about CDs, you don’t need 100% of your fixed income money for rebalancing. Usually you only need 1/4 to 1/3 of it. The bulk of your fixed income money can go into CDs.

For people in a high tax bracket investing in taxable accounts, muni bonds are still a better deal than CDs.

For the moment, let’s assume it’s in an IRA and the only choices we are considering are the Vanguard Total Bond Market Index Fund and CDs. In the article last week I showed a 7-year CD bought 4 years ago is projected to be a better deal when it matures in 3 years. Similarly, a 7-year CD bought now is also projected to be a better deal in the next 7 years.

Why don’t investors realize that CDs are a better deal and move from bonds to CDs? I have a few theories, none of which I can prove definitively. They probably all have a kernel of truth. I’m offering these up as possible answers to TJ’s question.

Bonds Used to Be Better

Long term data for CDs are hard to come by. St. Louis Fed has data for 5-year CDs from Bankrate.com since December 2000. The following chart shows the yield of 5-year Treasury minus the yield of 5-year CDs since December 2000. Positive numbers above the red line indicate Treasury yields were higher than CD yields.

Except during the financial crisis when Treasury yields were very low due to flight to quality, 5-year Treasury yield were in general higher than 5-year CD yield by about 0.5%. However I should note that hasn’t been the case since 2011.

Considering that agency and corporate bonds in a total bond market index fund usually have higher yield than Treasury, it’s fair to say that the bond fund had higher yield than CDs most of the time in the past. People remembered that but didn’t notice that time changed. CDs have better yield now.

Bonds Are Better Than Average CDs

The data for CDs in the chart above are for average CDs. If you just walk into a random bank, you are not going to get a rate as good as bond yields. I see Wells Fargo offers a 58-month CD paying 0.5%, a far cry from a 5-year CD from CIT Bank paying 1.75%, a 7-year CD from Discover Bank paying 1.9%, or even higher at some credit unions.

The Internet has made it much easier to find the best CD rates. It could be that the best CDs have always been better than bonds but people just didn’t know where to find them.

Mentally Associate CDs With Short-Term Savings

Bonds are a product of Wall Street. They are traded in the capital market. Bond funds buy, hold, and sell bonds. They are associated with investing. CDs are a retail product. They are associated with short-term savings. People don’t think about CDs when they are investing.

Institutional investors can’t deal with CDs. When they are talking about investing in fixed income, bonds are pretty much the only game. When they mention cash, they mean money market funds, not bank savings accounts or CDs.

In this otherwise excellent web cast from Vanguard, Ken Volpert, head of the Vanguard Fixed Income Group, made no mention of CDs as an alternative to bond funds, as if bank savings accounts and CDs don’t exist.

“And for investors who are sitting in cash, they’re basically earning zero. At least the bond market has given you a couple of percent returns. So if it takes a few years before we get back to normal, you could be losing a few percent a year relative by sitting in cash.”

Sitting in cash is not basically earning zero. If cash means bank savings account, you can get 1% or above 1% at some places. If cash means bank CDs, you can get the same “a few percent a year” or higher.

Want More Liquidity Than Necessary

Even when a bond fund is for long term investing, in an IRA for that matter, it’s fully liquid. You can sell all of it on a whim even though people know they are not supposed to do so and they won’t do so in reality. But they still like to feel they are in control. CDs on the other hand make people feel that the money is locked up, out of their control. If you want to sell you will have to pay an early withdrawal penalty. Nobody wants to hear the word “penalty” as if they did something wrong.

The desire for utmost liquidity for 100% of the money 100% of the time is irrational. When you invest for the long term, the money is already committed. You don’t need to have it all liquid at all times. Getting paid for illiquidity is one advantage small investors have over institutional investors.

Overvalue Simplicity

Having a bond fund together with stock funds all in one account is simple. Investing in CDs would require another account.

So? What’s the matter if I have to create another entry in my Microsoft Money software? I’d rather have a few thousand dollars more in my account than making my software neat.

Unfamiliar With The Ease of Buying

Inertia is a strong force. Even if evidence suggests CDs are better, people like to find excuses saying it would be too much trouble to make the switch. If they never had CDs in an IRA before, they may erroneously think it’s not possible or there are a lot of paperwork to do the transfer. Because people haven’t done it before, they are afraid they would do something wrong. They’d rather stick to the familiar than venturing out for something better.

In fact it’s very easy to buy CDs with money in an IRA at a different institution. You just fill out a form given to you by the bank or credit union. They will get the money transferred over. See the IRA transfer form from Discover Bank as an example. You do it once and you are good for 5 or 7 years. Money is not going to disappear mid-air during the transfer.


There you have it. Those are the reasons I can think of why people still invest in bonds not CDs. For people who really understand what’s going on, there’s little reason not to use CDs for the bulk of fixed income investments (except munis in taxable accounts). Even for TIPS for inflation protection, we have CD-like I Bonds as a better alternative. To recap,

  1. Bonds and CDs are not mutually exclusive. You can have both.
  2. Bonds used to be better than CDs but no longer.
  3. Bonds are better than average CDs but the best CDs you can easily find are better than bonds.
  4. CDs can be used for long-term investing as well as short-term savings.
  5. You don’t need to keep 100% of your money liquid 100% of the time. Don’t pay for liquidity you don’t need.
  6. Having another account is not going to kill you. It’s good for your bottom line.
  7. It’s very easy to transfer money to a bank or credit union for CDs, even in an IRA.

[Photo credit: Flickr user marttj]

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  1. indexfundfan says

    By “transfer”, do you mean the transfer of assets from one custodian to another?

    On Vanguard’s brokerage in-kind transfer form, it actually states that most CDs cannot be transferred.

  2. Harry says

    No. I meant transferring some dollars from an investment account to a bank or credit union to fund the CD. The bank or credit union will give you a transfer authorization form. It will go get the dollars from your investment account. Here’s an example from Discover Bank.

  3. foss says

    I think the location issue is the main problem (and the absolute $ increase in returns).

    There is no easy way for me to get my bond fund $ out of my 401k and into a CD. It is now becoming increasingly correct to say that fixed income at paltry yields should sit in taxable accts. The problem is that for those of us with large allocations to fixed income in a 401k, this would require selling the fixed income (bond fund/treasury/TIPS) buying equity funds in its place, then coming up with new $ to purchase fixed income outside of the tax deferred acct – ie in taxable. Assuming a constant portfolio size, this is possible only by selling equities in taxable accounts which then incurs more taxable loss.
    For 1% (e.g) of yield net of 30-40% of taxes, this is maybe $300-$500 net/year, at best (and potentially much worse based on tax status).
    Sometimes inertia makes sense, or is guided by the unknowns.

    If I could relocate my fixed income I would. At this point, I max out I-bonds and dump TIPS at around the same rate (buy I-bonds in taxable, dump TIPS in tax deferred), but it has for better or worse made me save more and buy more equities.

    I do think it is a bit more complicated and in many cases, not worth the time involved.

  4. Frank says

    I agree with your article Harry. Currently, the fixed income portion of my IRA consists of three individual share certificates, of equal funding, at a credit union. The average dividend rate of the combined certificates is 3%.

  5. John says

    You mentioned that “For people in a high tax bracket investing in taxable accounts, muni bonds are still a better deal than CDs.” How would I bonds compare given that you can defer all taxes till maturity (when you will be in a lower bracket)?

  6. Harry says

    John – I Bonds work just like a variable rate CD, tied to inflation, with tax deferral. Whether munis or I Bonds will have a higher return in the end is anybody’s guess. Because of the annual purchase limit, in a taxable account just buy both if you are in a high tax bracket.

  7. Ben says

    Harry, how do you compare interest rate risk between CDs and bonds of different terms? VBMFX says it maintains an average term of 5 – 10 years in the bonds it holds, and the SEC yield is 1.45%. The Discover Bank CD you mentioned has a 1.85% yield on a 7-year CD (already gone down??) Does that mean these two have comparable risk levels?

  8. Harry says

    Ben – The interest rate risk is lower in CDs because the early withdrawal penalty is fixed and because its remaining time to maturity declines over time.

  9. Mary says

    Very interesting articles about CDs vs. Bonds — it helps to clarify the decision of where to put our fixed income allocation. So, to recap:

    1) I could transfer assets from a Traditional IRA at Vanguard or a 401k at Schwab into a CD at Discover Bank? The assets would still be part of the IRA or 401k but would be held at Discover in a CD?

    2) How can IBonds be held in a taxable account? For instance, they could not be held in my taxable account at Vanguard, correct? They would be held at TreasuryDirect, right?

    3) For muni -bonds in taxable accounts for high-tax brackets, would you recommend buying the specific state bond in which I live which is Ohio?

    4) What is your opinion on CDs linked to baskets of commodities? Our former Morgan Stanley advisor has tied up $350,000 of our money in these CDS for the next 3 – 5 years….which is awesome (not).

    Thank you for directing me to your website through the Boglehead board….very informative and I look forward to reading more of your blog articles!

  10. Harry says

    Mary –

    (1) IRA yes, 401k no, unless you are talking about the 401k of a former employer or if you are already 59-1/2, which can be rolled over to a traditional IRA.

    (2) I Bonds will have to stay at TreasuryDirect or in paper form if you already have the paper bonds.

    (3) Assuming you are talking about the Vanguard Ohio Long-Term Tax-Exempt Fund, that’s fine.

    (4) Depending on the specific offer. See A Case Study On An Index Linked CD. If you are already in them, just hang on until they mature.

  11. Mary says

    Thank you, Harry. Interesting article about the Index linked CD, too. One more new Boglehead question:

    What is the best way to perform rebalancing asset allocation with money tied up in 5 year CDs vs. something like the Total Bond Fund?

  12. TJ says

    Do you feel like today CD’s are still a better deal than bonds?

    That Discover CD is up to 2.18% for a 7 year, BTW.

  13. Jim Pelluso says

    Nice article. I think you have summed up most of the reasons why CDs are underutilized. I think the fixed income side of investing has always been a bit of an after thought – just buy a decent intermediate bond fund. That used to be pretty much true. The real excitement and sales pitch was what are you doing with the stock side? Also, brokers/brokerage firms don’t make money on CDs.
    Another subtle bias is that CDs were for unsophisticated investors like grandma. Buying a CD is like having a rotary phone.
    Finally, recommended allocations used to be categorized as stocks, bonds and cash. The last decade or so “they” have dropped the “cash” part.

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