Bonds and CDs – What Are Their Pros and Cons?
Many financial advisors today tell their clients that once they reach retirement age, they should probably have at least some retirement savings housed in conservative, low-risk holdings. The question of how much money depends on many factors, including what someone’s personal risk tolerance is.
Often those holdings are made up of bonds, CDs, or other such instruments that don’t have the same volatility as stocks or stock funds do. That being said, these investments have their own set of pros and cons that can affect their performance over the long term. This is especially true when interest rates are low as they are now.
What Are Some Upsides for Bonds and CDs?
One of the main advantages to investing in bonds and CDs is their relative safety compared to investing in stocks. While stock prices will rise and fall in tandem with the markets, bond prices remain the same as long as you hold them until maturity.
CDs are backed by the FDIC, which is funded by the federal government. Treasury securities such as T-bills, T-notes, and T-bonds are also backed directly by the full faith and credit of the U.S. government. And government agency securities such as Freddie Mac’s and Fannie Mae’s are also backed indirectly by Uncle Sam.
Don’t Overlook the Trade-Offs
But the assurances that come with these guarantees also have trade-offs. While they provide the guarantee of your principal and interest payments, bonds and CDs are paying interest rates that are among the lowest in today’s financial marketplace.
As of now, it’s hard to grow your money faster than the rate of inflation in different types of bonds and CDs. Seeing how their current rates stand, CDs and Treasury securities are vulnerable to inflationary risk over time.
Those who purchase long-term instruments such as the 30-year Treasury bond may be locking in a very low rate of interest over the life of the bond. Interest rates are bound to start going up again sooner or later.
What Happens to Bonds When Interest Rates Go Up?
When they do, many people will want to get out of their current fixed-income holdings and buy new offerings that pay higher rates of interest. But if they have to sell their current holdings to do this, then they will realize a capital loss on the sales of their bonds.
This is because the value of their current holdings will decline in the secondary market. At that point, they are paying an inferior rate of interest compared to the new offerings that are available.
So bond investors must sell their current holdings at a discount in order to unload them onto someone else who is willing to hold them — at a reduced price.
A Quick Look at Municipal Bonds
Municipal bonds are another type of “safe” investment that comes with their own limitations. While the interest that these bonds pay is exempt from federal, state, and (usually) local income taxes, the rates of interest that they pay are correspondingly lower to begin with.
High-income investors tend to be the ones who flock to municipal bonds, as they are looking to save money on taxes. Middle and lower-class investors are usually better off buying bonds that pay taxable interest because they will have more left over after taxes than they would get from a municipal bond.
What About Corporate Bonds?
Corporate bonds pay the highest rates of interest — and also carry the highest degree of risk to the investor. Corporate bonds pay more interest than government or municipal bonds. However, there is also a correspondingly higher chance that the issuer could default on their interest payments if the issuing company experiences financial hardship.
For this reason, a rating system has been implemented for all types of bonds. The safest bonds (i.e. Treasury securities, etc.) get the highest safety ratings, and the ratings go down from there as the risk of default by the issuer increases.
Any bond with a rating below BBB or B++ is considered to be a “junk” bond. Junk bonds pay higher rates of interest compared to investment-grade bonds, but the odds that a junk bond issuer will default are also higher.
For this reason, junk bonds tend to be attractive to investors who are aggressively seeking higher levels of income for their money.
Alternatives to CDs and Bonds
There is one type of instrument that can pay higher rates of interest than bonds or CDs, while still guaranteeing your money.
Fixed annuities are often a happy medium between low-paying instruments such as Treasury securities and riskier investments such as junk bonds. Why? Because they pay a guaranteed rate of interest that falls somewhere between these two offerings without a high degree of risk.
The insurance carrier that issues a fixed annuity is required by state law to have at least one dollar in its cash reserves for every dollar in outstanding annuity premium that it issues.
Life insurance companies can’t levy taxes on the public or print their own money, as the U.S. government can do as it backs bonds and CDs. But life insurers don’t need to, as they already have the money sitting in their cash reserves.
Fixed Index Annuities
Fixed indexed annuities are another step up the ladder for those seeking higher growth for their money they can’t afford to lose. While a fixed index annuity pays interest rates that can vary, your principal inside the annuity is still guaranteed by the insurance company.
The interest that fixed index annuities pay depends upon the underlying financial benchmark index that they are tied to. Many indexed annuities are linked to the Standard & Poor’s 500 Price Index.
When the index goes up during a given crediting period, then interest earnings are calculated and then credited based on a portion of that increase. When the index goes down, your money is ‘locked in’ from the prior crediting period. It simply earns zero percent for that period, even though the index fell.
Because of this, the interest that you earn in a fixed index annuity isn’t guaranteed. However, on the whole, fixed index annuities have usually paid out more interest earnings over time than fixed annuities – or bonds and CDs, for that matter.
What Are Some Other Advantages That Annuities Offer?
Fixed and indexed annuities also grow tax-deferred. In other words, the growth of your money isn’t taxed until you start taking withdrawals from your annuity contract.
This is true regardless of whether the annuity is a standalone asset or if it’s held inside an IRA or employer-sponsored retirement savings plan. When you do start withdrawing money from your annuity contract, the withdrawals are taxed as ordinary income.
Furthermore, both fixed and indexed annuities can pay out a stream of guaranteed income that will last for as long as someone lives.
This income stream continues even if all of the interest and principal that has accumulated inside the contract is exhausted. Annuities are the only type of financial instrument that can provide this form of guarantee.
Exploring Your Options for Your Unique Retirement Goals
Consult your financial advisor for more information on these annuities and how they can benefit you. These options just may make the difference in helping you enjoy a comfortable lifestyle after you retire.
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