Key differences between debt funds and liquid funds

To understand the difference between debt funds and liquid funds, let us decode both these categories of mutual funds in further detail.

Aug 06, 2019 09:08 IST India Infoline News Service

Mutual Funds
Thanks to the popularity of liquid funds over the past few years, mutual fund investors are often known to confuse between debt funds and liquid funds. However, what they may not know is that while all liquid funds are debt funds, all debt funds are not liquid funds. Thus, they cannot be used interchangeably.

Debt funds refer to the category of mutual funds that invest in a pool of debt oriented or fixed income securities. Each of these securities have different maturity tenures and carry varying degrees of risk. Liquid funds on the other hand are essentially a subset of debt funds. These funds invest in securities that have a maturity profile of a maximum of 91 days.

To understand the difference between debt funds and liquid funds, let us decode both these categories of mutual funds in further detail.

Debt funds
Debt funds invest in a variety of fixed income instruments. These include treasury bills, government bonds, certificate of deposit, commercial paper, corporate bonds and money market instruments. There are various categories of debt funds. These funds are categorised on the basis of maturity profile. Thus, there are 16 categories of debt funds that include liquid funds, short duration funds, ultra-short duration funds, gilt funds and dynamic bond funds.

Debt funds are considered to be less risky as compared to equity funds. If you are investing with a short time horizon, where capital protection is your major objective, debt funds may be an ideal option. However, this is not to say that debt funds are free from risks. Debt funds carry the following risks, based on the fixed income instruments that they are investing in:
  • Interest rate risk: Debt funds invest in fixed income securities that are interest bearing. Prices of these funds fall when interest rates rise and vice versa.
  • Credit risk: Some debt funds invest in securities that carrying a low credit rating. This means that there is a risk of not receiving regular payments from their underlying securities.
  • Default risk: Though these instances are rare, some funds can face a default risk when the issuer of the bond fails to make the stipulated payment.
Liquid funds
Liquid funds are one among the category of debt funds. They invest in fixed income instruments with a maturity of no more than 91 days. Liquid funds are therefore considered an alternative to keeping your money idle in a savings account. You can also consider liquid funds for the purpose of maintaining a contingency or emergency fund.

Difference between debt and liquid funds
Now that you are acquainted better with debt and liquid funds, let’s take a closer look at their differences based on certain parameters.

Maturity profile
The first and most obvious difference that can be made between liquid funds and debt funds is on the basis of maturity profile. Liquid funds invest in fixed income securities that have a maximum maturity profile of 91 days. Additionally, these securities are held up to maturity.

However, this restriction is not applicable in the case of other categories of debt funds. The maturity profile of underlying securities of debt fund varies greatly. While there are debt funds such as overnight funds that invest in overnight securities with a maturity of one day, there are gilt funds that invest in government securities with a maturity of 10 years.

Liquidity
Liquid fund, as the name suggests, offer easy redemption facility. Some AMCs offer instant redemption facility on liquid funds. This means you can have the cash from liquidation of your units within 30 minutes into your account. Other categories of debt funds are not as liquid. Maturity proceeds may take up to two working days to come to your account after having placed a redemption request.

Risk
The risk component is considered to be at their lowest in liquid funds. This is largely because the maturity tenure of the underlying securities is very low. As a result, the interest rate risk and credit risk attached to these funds is minimum. On the other hand, there are debt funds that carry a high degree of interest rate risk and credit risk and may offer the potential of corresponding returns.

Now that you are aware of the differences between debt and liquid funds, it may help you to make a better-informed investment decision.

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