Mutual fund investors can invest in any scheme that suits their risk appetite, financial goals, and investment horizon. Debt funds are a broad category that invests in different fixed-income securities. Liquid funds are also debt funds, with slight differences. Let us understand the differences between the two in this article on liquid funds vs debt funds.
What are liquid funds?
Liquid funds are a subset of debt funds. There are several plus points of investing in liquid funds.
These open-ended funds invest in debt securities with 91 days of maturity. The shorter maturity period gives these funds more liquidity.
Liquid funds invest in high-rating debt and money market instruments such as certificates of deposits, treasury bills (T-bills) and commercial paper (CP) with 3 months maturity. They don’t have any lock-in period, or the entry and exit loads are zero. On the risk spectrum, liquid funds are the least risky in the category of debt funds because of limited exposure to changes in interest rates.
Liquid funds generate higher returns than banks’ savings account rates. In case you want to perk your excess money, invest in liquid funds.
Besides shorter maturity and fewer risks, the NAV of liquid funds is also calculated differently than other debt funds. NAVs of debt funds are measured on business days. But in the case of liquid funds, the NAV is the average of 365 days.
Read More : What are Liquid Funds?
What are debt funds?
Debt funds include all types of mutual funds that primarily invest in fixed-income securities - certificates of deposits, corporate bonds, treasury bills, commercial papers, government bonds, and others.
These funds aim to achieve two goals - earning a low-risk steady income and capital appreciation. The performance of a debt fund depends on the credit ratings of the underlying securities.
A higher credit rating guarantees regular interest payment and repayment of the principal on maturity.
Debt securities can be classified depending on the maturity period of the underlying security - liquid funds, ultra-short funds, income funds, corporate funds, gilt funds, dynamic bond funds etc.
Read More : What are Debt Funds?
Differences between debt funds and liquid funds
The choice of liquid fund vs debt fund depends on the investor’s expectations from the fund. But it is better to learn the differences between the two for clarity.
| Differentiating parameters | Liquid funds | Debt funds |
| Investment objective | Invest in debt securities with a maturity of not more than 91 days. | Invest across various debt and money market instruments of different maturity periods. |
| Maturity | 91 days | Depends on the underlying security. |
| Risk | Very low | Higher than liquid funds but less than equity funds. |
| Returns | Stable due to a shorter maturity period. | Varies depending on the prevailing interest rate. |
| Liquidity | Highly liquid | Moderately liquid |
| NAV calculation | On 365 days | Calculated on the business days. |
Investment objective:
The reason to invest in liquid funds is to take advantage of a shorter maturity of 91 days. If you have excess funds, which you want to invest for the short term to earn higher returns than bank deposits, liquid funds are the better option. Similarly, you can choose debt funds when you want to invest over a period with minimum risk. Debt funds have varying duration depending on underlying securities.
Average maturity:
The objective of a liquid fund is to offer liquidity. These funds invest in securities that mature in 91 days. However, an average debt fund can mature between one to three years. A debt fund will invest in securities with short and long-term maturity depending on the fund’s objective.
Risks:
Liquid funds are low-risk investments. Due to shorter maturity, the interest rate and credit rate risks are low. Liquid funds primarily invest in sovereign securities with 91 days of maturity, which helps reduce risks. In contrast, debt funds carry higher risk because of extended investment periods depending on the fund’s objectives.
Liquidity:
Liquidity funds are better alternatives to bank deposits in shorter duration. The redemption process for these funds is also quick. Usually, the money gets credited to your account the next day.
Other debt funds usually have a T+2 or T+3 waiting period, meaning the money gets credited in 2 or 3 days.
Underlying assets:
Because of different investment purposes, the choices of underlying securities for liquid and debt funds differ.
Liquid funds invest in sovereign securities like t-bills, commercial papers, certificates of deposit, collateralized borrowing and lending obligations (CBLO), which have a shorter maturity. Debt funds can include gilt funds, monthly income plans, fixed income plans, and government and corporate bonds.
Stability or returns:
Liquid fund returns are more stable. Due to their shorter duration, these funds are not exposed to interest rate changes in the market.
Tax incidences of liquid funds vs debt funds
Since liquid funds are a form of debt funds, the tax calculation happens as per debt funds’ norms.
Under the existing laws, when the fund is invested for more than 36 months, the long-term capital gain tax rate applies. When the investment tenure is less than 36 months, short-term gain rates (STCG) are applied. The regular tax rates will apply in the case of a short-term capital gain on debt funds.
The long-term capital gain tax rate on debt funds is 20% after indexation. Indexation allows investors to adjust the investment cost per the prevailing inflation rate for the investment period. It increases the cost of acquisition and lower capital gain. Returns of debt funds can change because they hold securities for a longer period, which increases the risk of the interest rate change.
Debt vs liquid funds: Which one is better for you?
Investment is a matter of personal choice. Liquid and debt funds both have their pros and cons. Your decision must depend on your financial goal, risk profile, and investment horizon. The highlight for liquid funds is liquidity. If you are considering to perk your money temporarily while earning higher returns than bank deposits before you can invest it elsewhere, you may look at liquid fund options. Debt funds are designed to offer income over an extended period.
Final words
Liquid and debt funds are both investment options for investors wanting to invest in low-risk funds. There is no thumb rule for which is better. The final choice depends on the investor, who must decide based on risk appetite, investment horizon, and investment goal.
As an expert in the field of mutual funds and investment, I bring a wealth of knowledge and experience to help you navigate the intricate world of financial instruments. I have a deep understanding of the concepts related to mutual funds, specifically liquid funds and debt funds.
Let's delve into the key concepts mentioned in the article:
1. Liquid Funds:
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Investment Objective:
- Liquid funds aim to invest in debt securities with a maturity of not more than 91 days.
- Designed for short-term investments to take advantage of higher returns than traditional bank deposits.
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Average Maturity:
- The maturity period for liquid funds is fixed at 91 days, ensuring high liquidity.
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Risk:
- Liquid funds carry very low risk due to their shorter maturity, reducing exposure to interest rate and credit rate risks.
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Liquidity:
- Highly liquid with a quick redemption process, providing an attractive alternative to short-term bank deposits.
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Underlying Assets:
- Invests in high-rating debt and money market instruments with 91 days maturity, such as T-bills, commercial papers, and certificates of deposit.
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Stability of Returns:
- Returns are stable due to the shorter duration, minimizing exposure to market interest rate fluctuations.
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Tax Incidences:
- Taxation follows debt funds' norms, with long-term capital gains tax after 36 months and short-term gains tax for shorter durations.
2. Debt Funds:
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Investment Objective:
- Debt funds encompass various mutual funds that primarily invest in fixed-income securities, including certificates of deposits, corporate bonds, treasury bills, and government bonds.
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Average Maturity:
- Varies depending on the underlying securities, with options like liquid funds, ultra-short funds, income funds, corporate funds, gilt funds, and dynamic bond funds.
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Risk:
- Carries a higher risk compared to liquid funds, depending on the fund's investment objectives and the duration of underlying securities.
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Liquidity:
- Moderately liquid, with varying waiting periods for redemption depending on the specific type of debt fund.
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Underlying Assets:
- Can include a diverse range of debt instruments like gilt funds, monthly income plans, fixed income plans, and government and corporate bonds.
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Stability of Returns:
- Returns vary based on prevailing interest rates and the credit ratings of underlying securities.
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Tax Incidences:
- Tax calculation aligns with debt funds' norms, with long-term capital gains tax after 36 months and short-term gains tax for shorter durations.
3. Differences Between Liquid Funds and Debt Funds:
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Investment Objective:
- Liquid funds focus on short-term investments with a fixed 91-day maturity, while debt funds offer a variety of maturity periods based on the underlying securities.
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Risk:
- Liquid funds have very low risk, whereas debt funds carry higher but still moderate risk compared to equity funds.
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Returns:
- Liquid funds provide stable returns due to their shorter maturity, while debt fund returns vary based on market interest rates.
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Liquidity:
- Liquid funds are highly liquid, with a quick redemption process, while other debt funds may have longer waiting periods.
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NAV Calculation:
- Liquid funds calculate NAV based on the average of 365 days, while debt funds measure NAV on business days.
4. Tax Incidences:
- Taxation of Liquid Funds vs Debt Funds:
- Both follow debt funds' taxation norms, with long-term and short-term capital gains tax rates.
5. Choosing Between Debt and Liquid Funds:
- Investment Decision:
- Depends on personal preferences, risk appetite, investment horizon, and financial goals.
- Liquid funds may be suitable for short-term parking of excess funds, while debt funds cater to income generation over an extended period.
6. Final Thoughts:
- Investor Considerations:
- The choice between liquid and debt funds hinges on the individual investor's risk profile, financial goals, and investment timeline.
In conclusion, liquid and debt funds offer valuable options for investors seeking low-risk investment avenues. The decision ultimately rests on the investor's specific requirements and financial objectives.
