Whether you're saving money, seeking an income stream or looking to diversify a stock portfolio, fixed-income investing deserves a look. Bonds and CDs are among the most popular fixed-income investments , each with income payments for a designated period of time.

Knowing how to choose between CDs or bonds requires the investor to understand both the investments and his or her requirements.

A certificate of deposit, or CD, is a type of investment product typically offered by a bank or credit union. Investment firms also offer brokered CDs that can be purchased though an investment account. CDs are attractive as they are insured by the Federal Deposit Insurance Corp. for up to $250,000 per depositor, per bank. CDs can be purchased for various terms from six months up to five years.

See:

If held to maturity, the purchaser receives the stated interest payment at regular intervals and the principal at term. Although, if redeemed before maturity there is typically a loss of interest.

Bonds come in a wider variety than CDs and are considered a loan to the issuer. Governments, municipalities and companies issue bonds for varying durations with diverse interest or coupon rates. Bonds are bought and sold through a brokerage account at issue or on the open market, like stocks. The government sells its bonds at TreasuryDirect.com.

Bonds are issued with a specific interest or coupon rate. Although, if traded on the open market, the bond may sell at a premium or discount to its original price, thereby influencing the yield to maturity.

"The important factors when choosing fixed-income investments include risk tolerance, the amount of time the investment will be needed and tax treatment," says Carlos Dias Jr., wealth advisor at MVP Wealth in Orlando, Florida.

Bonds vs. CDs: Security

When investing in fixed income, consider default risk and loss of principal. FDIC insurance makes CDs a safe choice as long as the owner stays within the $250,000 FDIC insurance limit. CD investors are assured of receiving the stated interest payment and return of principal when held to maturity.

Investing in savings bonds and other government bonds is extremely safe. It's unlikely that the U.S. government will default on its debt. Like CDs if held to maturity, Treasury bonds return the principal and promised interest payments.

Corporate and municipal bonds are rated so investors can ascertain the risk of default for specific issues. Lower-rated bonds have a higher default risk and typically pay higher rates of return.

In most cases, if held to maturity, a bond will return the par value or face value of the bond and all promised income.

"Non-guaranteed bonds including nearly all corporate bonds and many municipal bonds are said to have credit risk since you might not receive all of the principal upon maturity," says Steven Jon Kaplan, CEO at True Contrarian Investments in New York. Should a bond issuer default, the purchaser will sacrifice income and or principal.

Bond funds and individual bonds sold before maturity are subject to principal risk, which means that a bond might be worth more or less than its face value, if sold before maturity.

"Bond prices have an inverse relationship with interest rates, meaning when interest rates go up bond prices go down and when interest rates go down bond prices go up," says Tim Neuville, senior director at Marcum Financial Services in Irvine, California. Longer duration bonds and funds will vary in price with changes in interest rates more than short-term bond investments.

That's why shorter-term investors might gravitate toward CD, individual bond investments, or short-term bond funds.

Bonds vs CDs: Income

Both bonds and CDs offer income. The frequency of the income payment depends upon the individual holding. Funds and CDs typically pay income monthly while individual bond's income schedules vary.

The income payment is set at purchase with both bonds and CDs.

Presently, In terms of generating interest income, the top-yielding CDs exceed those of Treasurys by a wide margin, says Greg McBride, chief financial analyst at Bankrate.

See:

It's useful to understand that riskier investments and longer-term bonds typically offer higher yields. Although, that's not always the case. During times of expected economic contraction or decline, the yield curve may invert. An inverted yield curve means that long-term interest rates are lower than shorter-term bonds of the same type.

"Investors have to resist the temptation to chase yield by going into riskier bonds in pursuit of higher yield. The top-yielding CDs offer the only free lunch of additional yield without having to take additional risk. Investors desiring higher yields will subject themselves to bonds with increasing levels of default risk," McBride says.

Bonds vs. CDs: Taxes

When investing, taxes matter. Regardless of stated returns, if bonds or CDs are highly taxed, the after-tax return is key, not the stated interest or coupon rate.

CD interest is taxed at ordinary income rates. If an investor buys a $10,000 CD yielding 3%, the annual interest is $300. But if the purchaser is in the 22% federal tax bracket he or she pays $66 in federal taxes plus any state or municipal taxes, says Megan Gorman, managing partner at Chequers Financial Management.

Various bond varieties offer tax advantaged income streams. Municipal bonds are federally tax-free, and if issued in the investor's state of residence may also be free of state state taxes.

U.S. government-issued bonds are typically only taxable by the federal government, not the state.

When choosing between taxable and municipal bonds and CDs, visit an online tax-equivalent calculator, to compare returns of distinct fixed-income investments on an after-tax basis.

Bonds vs. CDs: The Bottom Line

A good strategy for fixed-income investing works with both bonds and CDs. Since interest rates change, it's smart to own bonds and CDs of various maturities and credit qualities.

A laddering approach recommends investors buy fixed-income bonds or CDs with varying maturities, so that part of the investor's fixed portfolio will mature at different times. The advantages to laddering include taming the impact of interest rate variability. When interest rates go up, investors have additional cash to reinvest and capture higher returns. Laddering also frees up cash intermittently for other needs.

When interest rates are declining, buying longer-term bonds and bond funds might lock in higher yields. When interest rates are rising, lean toward short duration fixed-income investing, so when interest rates rise maturing funds can be redeployed into higher yielding bonds and CDs.

Read:

Finally, both individual bonds, bond fund and CD investing have advantages and disadvantages. When deciding among fixed-income investment options, consider your risk profile, time horizon and tax situation. Look for the highest after tax yielding instrument with a comfortable amount of risk.

For the simplest fixed income investing, choose diversified bond funds such as iShares Core U.S. aggregate Bond ETF (ticker: AGG ), CDs, and a municipal bond fund if taxes are a problem.

7 Investing Lessons Dad Forgot to Teach

Compare Offers

Compare Offers