How bonds and CDs earn money

Bonds and certificates of deposit (CDs) generally pay interest at predetermined intervals. Interest payments are commonly referred to as coupons. Sometimes, bonds can be issued as a "zero coupon." In these cases, the bond is typically issued at a discount (meaning at a price less than par) and matures at par value. This article focuses on bonds and CDs with interest (or coupon) payments.

If you buy a bond or CD at par value, then the coupon is the same as the annual percentage yield (APY), provided that you hold the CD through the maturity date and the security doesn’t default. The coupon is how much money is paid to you at the payment frequency as described at the time of purchase. Coupon payments are deposited into your cash core account, not reinvested into the bond or CD. As a result, bonds & CDs pay simple interest.

APY is expressed as an annualized rate of return. It is the total amount you make on an investment, including not only the coupon payment but also any compounding if the coupon interest is reinvested, as well as any gains due to purchasing a bond at a discount to par value or losses due to purchasing a bond at a premium to par value. A bond or CD purchased at exactly par value, meaning $1,000, and held to maturity will not have gains or losses, and therefore, the coupon payments will match the APY.

Let's look at a few examples using a new issue brokered CD that does not compound the coupon payments.

Let's say you invest $1,000 into a CD paying 3% APY and that the CD matures in 1 year (365 days). At maturity, the interest you earn would be $30 (3% of $1,000 = $30). Because the CD pays interest semiannually, you would be paid $15 of interest after 6 months and another $15 at maturity. When the CD matures, you would also receive the initial $1,000 principal you invested.

In our next example, you invest $1,000 into a CD paying 3% APY but the CD matures in just 6 months (180 days). Although you are earning at the same rate of return, you are only investing for half as long. Therefore, the CD earns half as much as in the 1-year example (a total of $15 in interest). Remember, the total return you receive in cash terms is proportionate to the length of the investment period.

In the final example, you invest $1,000 into a CD paying 3% APY, but the CD matures in 2 years (730 days), so the total interest you earn would be $60. Because the CD pays semiannually, you would earn $15 of interest after 6 months, 12 months, 18 months, and a final $15 at the 2-year maturity mark. As with the other examples, the coupon payments on a brokered CD are not compounded, and you would also receive the $1,000 of principal that was initially invested when the CD matures.

The total potential amount you can earn on a new issue CD investment is expressed as APY. With bonds and brokered CDs trading in the secondary market, you will see the same concept of an annualized yield depicted as the Yield, specifically the "Yield to Maturity" or the "Yield to Worst." The Yield to Worst is equal to the Yield to Maturity if the bond or CD is call protected, and for callable bonds, it is the lower of either the Yield to Maturity or the Yield to Call. Remember, the APYs or yields displayed are annualized calculations and assume that the instrument is held through maturity or its call date.

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Examples contained within this page are hypothetical, and for illustrative purposes only.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Your ability to sell a CD on the secondary market is subject to market conditions. If your CD has a step rate, the interest rate of your CD may be higher or lower than prevailing market rates. The initial rate on a step rate CD is not the yield to maturity. If your CD has a call provision, which many step rate CDs do, please be aware the decision to call the CD is at the issuer's sole discretion. Also, if the issuer calls the CD, you may be confronted with a less favorable interest rate at which to reinvest your funds. Fidelity makes no judgment as to the credit worthiness of the issuing institution.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917