Bonds Vs Savings Accounts

Bonds Vs Savings Accounts

We all like to see our money multiply whether it is in the form of income building up, through investments, or with careful spending and saving strategies intended to keep money in our pockets. But we often wonder if we are doing enough with our money, putting it in the right place or managing it correctly. While there are plenty of professionals that can assist with our best practices when it comes to finance, a basic understanding of how to treat the money you have on hand can help you maximize your cash assets.

Most people know that keeping your cash in a savings account is beneficial, but many may not really understand the benefits and pitfalls of doing so. In contrast, utilizing a savings account in comparison to investing in bonds to make and save money is usually beyond most people's comfort zone. Let’s take a look at what a savings account and a bond actually are and how they work for you.

Bonds Vs Savings Accounts

What is a Savings Account?

Simply put, a savings account is an account at a bank as a location to keep your money safely stored. A savings account is typically the type of account that you will not need to access daily, and you may have a limitation on the number of times per year you can access the account. These accounts are a way for banks to have cash on hand to use as their own loan capital, and they actually pay you a small amount to store your money with them.

How Much Money You Can Earn on a Savings Account

Since you are essentially lending a bank your cash, the bank will pay you a percentage of your deposit over the course of a year. The national average of Annual Year Yield, or APY, that you can earn from a savings account hovers near .50% of your balance over a year. While you may not become rich by simply having a savings account, it can be a steady income on money that is not touched over a longer period due to the compounding interest as your nest egg grows.

Is My Money Safe in a Savings Account?

Knowing your financial investments are safe is something we all want. When we don’t use a bank or financial institution that is insured, we run the risk of our money investments or holdings are not safe as well. Luckily, the FDIC (Federal Deposit Insurance Corporation) is a Congress-created independent agency that assures that your investments with banks, like Savings Accounts, are safe up to $250,000 per account. Your savings in this type of account are assured to be safe for up to that amount, so you can feel secure that your money is safe in a savings account.

Bonds Vs Savings Accounts

What is a Bond?

Unlike a savings account, a bond is essentially a loan that an individual gives to a large financial institution. The agreed upon sum is deposited with an institution, and an end date is given. This is the date that the money is accessible again by the individual; the bank will be utilizing this asset until then in their own loan processes, most likely. Usually, banks use the bond investment over the agree-upon time period, with the end date called the maturation time. As a thank you for allowing your bond investment to be used, you will earn a small interest payment over the life of the bond.

Is My Money Safe in a Bond?

Bonds are investments, so there is always a very small possibility you can lose your money if the financial institution defaults on their loan. However, bonds are almost always seen as a strong, safe investment for individuals since defaulting on loans is exceedingly rare for financial institutions that issue bonds. If you do not withdraw your initial investment (called the principal or face value), you will earn not only yearly interest but also you will receive 100% of the principal back at the maturation date. If you choose to withdraw your bond principal prior to the agreed-upon maturation date, you will not be given back the whole face value of the bond and won’t earn the yearly interest on any future dates once the bond is cancelled or withdrawn.

Bonds Vs Savings Accounts

Types of Bonds

While the structure of a bond is basically the same in all instances, there are multiple types of bonds that can be purchased, or invested in, by private individuals or businesses. Each type of bond has its own risk level, length of time until maturity, and interest rate (also called a coupon rate) at which the investment pays off to the buyer.

Savings Bonds

These bonds are different than the other bonds as savings bonds are purchased for less than their face value. Upon maturation which can sometimes be many years, the bond matures, and the face value can be redeemed. These bonds do not pay out any interest during the life of the bond. Instead, the accrued profit is realized when the bond is mature and the face value is now how much the bond can be redeemed, or sold, for by the investor.

Treasury Bonds (T-Bonds)

T-Bonds are what most people think of when they describe bonds. These are bonds from the government that last for 10-30 years and are generally considered to be risk-free since they are guaranteed by the government. These bonds pay out interest every six months. Treasury Bills and Notes are the shorter version of T-Bonds as they mature in as early as 1 year and as long as 10 years.

Municipal Bonds

Muni bonds, as they are also known, are bonds that are offered up by local governments rather than the federal government offering of T-bonds. State and local governments offer up the Muni bonds in order to raise money for their state, area, or city needs. These bonds are slightly riskier than T-bonds, but generally assumed to also be a low risk, guaranteed investment. Since these are tax-exempt investments, Municipal bonds are popular for that savings perk. Additionally, these bonds mature at different lengths of time, so their flexibility is attractive as well.

There are two types of municipal bonds:

  • General Obligation Bonds: not tied to a specific project and are paid back with general funds
  • Revenue Bonds: connected to a specific project, like a toll road or athletic venue construction

Corporate Bonds

This bond is issued by a private corporation, rather than a local or national governmental agency. Since the security or safety of these bonds are directly connected to a corporation’s financial well-being, the bond is given a rating of AAA (the highest) to C or D (the lowest) to inform consumers of their risk in the investment. The rating companies are essentially watchdogs to make sure that a company uses the financial investment wisely and that those that purchase the bonds from private companies can easily understand the upfront risk they are assuming when buying this bond.

There are a few different kinds of Corporate bonds, but these are the three most common:

  • Fixed Rate: also called Plain Vanilla Bonds, these have variable lengths and interest rates and are generally the least risky.
  • Convertible: like Fixed Rate, but upon completion or maturation, these bonds can be converted into corporate stock.
  • Junk: very low cost but high risk of loss of the investment; will yield high payout at maturation if the investment is not defaulted or lost by the corporation.
Bonds Vs Savings Accounts

Choosing Between Bonds and Savings Accounts

All types of financial products have positives and negatives for investors. While the desired outcome always involves an increase in capital, differing risks and types of payouts necessarily come with varied results. So how do you decide what kind of investing vehicle is best for you? Let’s look at a close comparison between bonds and savings accounts to discover the pros and cons for each for the average investor.

Measure Your Risk Aversion

Do you need low or almost no risk in your investing? Or are you comfortable holding investments that hold some or a lot of risk in their payoff potential? In deciding between a bond and a savings account as an investment, your ability to deal with risky investments should be a key factor. Many people find their risk comfort zone to be somewhere in the middle, giving more options for choosing between these two types of money investments.

Zero or Almost Zero Risk

Savings Accounts have zero risk for accounts that hold up to $250,000, with the FDIC backing all accounts up to that amount should a bank fail and lose this money before the account holder could withdraw or move the money from the savings account. If you are not comfortable with any risk at all, a savings account will provide that option for accounts that meet that balance threshold.

Another low-risk or almost no-risk investment is the treasury bond, as they are guaranteed by the national government. Unlike the FDIC backing of the bond, the T-bond is always guaranteed as long as the government is running. This risk security only applies to the US government. Even though other countries do issue their own treasury bonds, each country has their own assurances and risks that are not identical to the t-bonds from the USA.

Minimal to Some Risk

If a little more risk is more your style, then corporate bonds can be a match for your style of investing. Corporate fixed rate or convertible bonds have minimal but some clear risk. Doing research on the specific bond you choose through the watchdog companies Moody’s and Standard and Poor’s is a must, as is choosing bonds with the highest ratings, like AA or AAA. These bonds are likely to be a secure investment, and it is probable that they will meet their bi-yearly interest payments as well since they are rated highly enough to be.

For an even better end to the bond, choosing a convertible bond allows you to roll your earnings over into stock for the company. While you won’t see the return of your principal coming directly back into your hands until you sell your stocks, this type of bond is not any riskier than a fixed rate one.

Highest Risk Brings Greatest Reward

Riskier bonds like BB and below rated bonds as well as the lowest rated bonds, or junk bonds, hold the highest risk for all bonds. This means you could be left with no money upon the bond maturation date, but with the higher risk comes greater reward. Junk bonds that do result in a successful payout have a much higher interest rate meaning your final income from this highest-risk bond can be substantial. Many investment advisors discourage this type of investment, however, since so few actually result in a return on investment and are too risky for the average investor.

When Do You Need Your Money?

Another key to deciding between bonds and savings accounts as an investment strategy is to know when you need access to your funds. Each of these has a specific methodology for access to your funds and knowing when or if you need to access your money in the next months or years is something to understand before committing to a bond or savings account.

Savings Accounts Give Limited Access All the Time

If you choose to put your funds into a savings account, you will be limited to usually 6 transfers of the funds per month (but check with your institution for their exact, current rules.) Normally funds can be withdrawn via ATM or teller without penalty or limitation, but during 2020’s pandemic the monthly transfer limitations were waived for some institutions. A savings account is an accessible location for your funds, but remember that when the balance decreases, so does the APY at the end of the year.

You Need Your Principal in a Year (or Years)

For those that do not need constant access to the funds, a bond is the best fit for this type of money management. Bonds are issued, or bought, in time-specific increments. Bonds can be found in many yearly quantities, so matching up a need for 2, 5, 10 or even longer timeframes is possible with bonds. T-bonds have the shortest maturation times, while municipal and corporate bonds provide more flexibility and longer maturation times.

Bonds, however, are not accessible before their maturation date without a steep penalty on the principal, meaning you won’t be able to withdraw the total principal amount until the agreed-upon date at purchase. Bonds are not a good money-making strategy if you need to have the money at hand at any time during the bond length as it is tied up as a loan for the issuer's use during the time of your bond maturation.

How Much Profit Can I Expect?

Bonds and savings accounts both add to your bottom line, but each has a specific amount of profit you can expect to earn in a set timeframe. Savings accounts give a steady payout with compounding interest best felt over time. Bonds, however, can show a profitable turn duwith bi-yearly interest payouts (but not savings bonds) as well as at the maturation. Higher risk bonds can provide a large financial gain, potentially, but often they also result in a complete loss with the riskiest of investing into low-rated or junk bonds.

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