Liquid Funds vs Debt Funds

Read this article to get a detailed comparison of liquid funds vs debt funds.
EXPLORE FUNDS
Liquid Funds vs Debt Funds
EXPLORE FUNDS
3 mins read
12-Apr-2024

nvestors in India can choose from different types of mutual funds. Among these are liquid funds and debt funds, which are popular for different reasons. Although both these categories of funds invest in debt instruments, there are a few crucial factors that set them apart. This article offers a detailed comparison of liquid funds vs debt funds.

What are debt mutual funds?

Debt mutual funds are investment vehicles that pool money from several investors and invest the capital in a wide range of fixed-income debt securities. Government bonds, corporate bonds and money market instruments are some examples of the kinds of assets these funds invest in. Debt mutual funds typically come with low to moderate risk and have the potential to generate steady returns.

What are liquid funds?

Liquid funds are debt mutual funds that invest exclusively in ultra-short-term debt instruments with maturities of up to 91 days. Certificates of Deposit (CD), Commercial Paper (CP), Treasury Bills (T-Bills) and Collateralised Lending and Borrowing Obligations (CBLO) are some types of assets liquid funds invest in. One of the defining features of these funds is that they are highly liquid. This allows investors to easily purchase and sell units of such funds at any point in time.

Liquid funds vs debt funds - Which is better?

Understanding the differences between liquid funds and debt funds can help you make informed investment decisions about choosing between the two. Here is a table outlining the key factors that set these two funds apart.

Particulars

Liquid funds

Debt funds

Tenure of debt securities

Up to 91 days

Ranges from a few days to a few years

Risk level

Low

Comparatively higher than Liquid Funds

Return generation potential

Lower than other debt funds

Higher than liquid funds

Liquidity

Highly liquid

Comparatively lower liquidity

Exit load

Upto 7 days exit load is applied on all liquid funds

Exit loads are levied

 

  • Liquid funds vs debt funds - Investment horizon
    The investment horizon of liquid funds is very short and typically does not exceed 91 days. In the case of debt funds, the investment horizon may range anywhere from days to years, depending on the type of fund you invest in.
  • Liquid funds vs debt funds - Risk
    Since liquid funds invest in high-quality debt instruments with very short maturities, the risk involved is lower. The risk is much higher with debt funds since they invest in multiple securities with different credit ratings and maturity periods.
  • Liquid funds vs debt funds - Liquidity
    Liquid funds enjoy significantly higher liquidity compared to debt funds as they can be redeemed within hours. The redemption process for debt funds, however, may take a few days.
  • Liquid funds vs debt funds - Tax benefits
    The returns and dividends from both liquid funds and debt funds are taxable. However, the rate of tax on the gains depends on the holding period.
  • Liquid funds vs debt funds - Stability of returns
    The returns from liquid funds often tend to be more stable due to their shorter maturity periods and higher-quality assets. Debt funds, meanwhile, may be more volatile due to the mix of securities with varying credit ratings and maturities.

Factors to consider before investing in liquid funds or debt funds

Whether you wish to invest in liquid funds or debt funds, there are three key things you must consider.

  • Historical performances.
    Comparing the track record of liquid funds and debt funds should give you insights into how they have performed through various market scenarios. This can help make your decision much easier. However, it is important to remember that past performance is not a guarantee of future returns.
  • Expense ratio
    The expense ratio is a fee that mutual funds levy on your investment to cover their operational costs. Liquid funds generally tend to have lower expense ratios than debt funds. However, even among liquid funds, the expense ratio may vary significantly.
  • Diversification
    Investing in a diverse class of assets can help reduce investment risk. Debt funds are traditionally known to offer better diversification than liquid funds. However, liquid funds generally have much lower risk to begin with.

Conclusion

Liquid funds offer high liquidity and stability, making them ideal for investors with shorter investment horizons. Debt funds, meanwhile, are good investment options for investors with moderate risk tolerance looking for potentially higher returns. That said, remember to compare mutual funds with each other to determine the one that is right for you. This way, you can ensure that you make an investment decision that matches your requirements.

Frequently asked questions

What is the difference between debt and liquid funds?

The primary difference between liquid funds and debt funds is the assets they invest in. Liquid funds invest in very short-term instruments like Treasury Bills and Commercial Paper with tenures of up to 91 days. Meanwhile, debt mutual funds invest in fixed-income securities like corporate bonds and government securities with tenures ranging from a few days to a few years.

What are the disadvantages of liquid funds?

Some of the major disadvantages of liquid funds include lower potential returns, interest rate risk and market risk.

Is it good to invest in debt-liquid funds?

Yes, liquid mutual funds invest in very short-term debt instruments, making them ideal for investors who wish to park their idle funds safely while continuing to enjoy moderate returns.

Is a liquid fund taxable?

Yes, liquid funds are taxable. The rate of tax applicable to the returns generated by the fund varies depending on whether you hold the fund for less than 3 years or more than 3 years. If the holding period is less than 3 years, the returns are classified as Short-Term Capital Gains (STCG) and are taxed at the income tax slab rate applicable to you.

If the holding period is more than 3 years, the returns are classified as Long-Term Capital Gains (LTCG) and are taxed at 20% with indexation benefits. The dividends from liquid funds, if any, are added to your overall taxable income and are taxed at your income tax slab rate.

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