Debt Funds Vs Liquid Funds: What Makes Them Different?

Debt Funds Vs Liquid Funds: An Overview

Every individual wants to invest their money to earn an extra income, fight inflation, or face the uncertainty of the future, but it is difficult to choose between the various options available in the market. Debt funds are part of the bigger picture of mutual funds, and liquid funds are a part of debt funds. This article brings to you details on liquid funds vs debt funds on the basis of investment horizon, risk and returns an individual wants to achieve.

What Are Debt Funds?

Debt Funds is an option available in a mutual fund scheme that invests in securities that offer secured returns such as corporate and government bonds, corporate debt securities, etc. Like debentures which are considered to be a safe option and provide assured returns, debt funds are also one such scheme available for risk-averse investors. 

Unlike equity funds which fluctuate on a real-time basis based on the stock market, debt funds will receive the interest, say once a year and the price is adjusted on a daily basis. Therefore, debt funds provide assured returns and fixed-interest income. SEBI (Securities and Exchange Board of India) has divided debt funds into 16 categories based on different characteristics such as duration and liquidity. Overnight funds, liquid funds, ultra-short duration fund, money market fund, medium duration fund, long duration fund, banking and PSU fund are some of the schemes available in the debt fund category.

What Are Liquid Funds?

Liquid funds are actually a subset of debt funds that invest in securities of maturity of up to 91 days only. These funds invest in securities that are highly liquid and provide assured returns such as Commercial Paper (CP), Treasury Bills (T-Bills), etc. These funds will be good for investors who don’t want to block their money for a long time. It is one of the funds available in the debt fund scheme as mentioned by SEBI, which has the primary characteristic of maturity of up to 91 days and is an open-ended scheme, which means that it can be sold or bought anytime. The Net Asset Value (NAV) can be calculated at the end of the day based on the underlying securities.

Difference Between Debt Funds and Liquid Funds

Even if liquid funds are part of a debt fund, there can still be a difference between liquid and debt fund.

• Investment Horizon: The investment horizon is one of the important factors in the difference between a liquid fund and a debt fund. Liquid funds will have a maturity of up to 91 days and can be held till the end of the day. Debt funds will not have a particular investment horizon. They can vary from short-term, medium-term or long-term based on the investor’s preference. 
• Risk: As mutual funds say, “Mutual fund investments are subject to market risks”. This also applies to debt funds and liquid funds. Though both debt funds and liquid funds are for risk-averse individuals, the risk associated with debt funds vs liquid funds is that liquid funds are less risky as compared to debt funds as they are for short-term periods. Investors can invest for the short term and maintain the liquidity in their hands for immediate purposes. Debt funds will have high credit risk and interest rate risk and there is a slight uncertainty attached to them because of the longer duration.
• Liquidity: Liquidity means how one can easily convert non-liquid assets into cash for use. There is also a difference between the liquid fund and the debt fund in terms of the liquidity they offer. Liquid funds are an open-ended scheme, which means that they can be redeemed at any time and investors can exit the scheme without any charges. Other schemes offered in debt funds are not liquid and can only be redeemed only after the next day's business cycle. One should invest in debt funds based on the average maturity of the portfolio as it contains different schemes of different maturities.
• Tax Benefits: Though there are points on liquid vs debt funds, tax benefits are the same for both. Dividends earned from debt funds are exempt from tax. Although mutual fund companies must pay the tax on their income as Dividend Distribution Tax, long-term capital gains (funds held for more than 36 months) are also taxed based on different rates, but short-term capital gains (funds held for less than 36 months) are taxed according to which tax category an investor belongs to.
• Underlying Assets Involved: On the basis of time horizon, the underlying assets in debt vs liquid funds are differentiated. The assets involved in liquid funds can also be part of debt funds. Liquid funds invest in short-term securities such as T- Bills, CP, CD, and CBLO and debt funds also invest in these securities including gilt funds, fixed maturity plans, monthly income plans, government and corporate bonds, etc.
• Stability of returns: The difference between liquid funds and debt funds in terms of the stability of returns is that liquid funds are more stable in terms of returns because of their short-term duration and therefore less linked to interest rate movements in the market. Debt funds can hold securities for a longer duration, therefore they are likely to be affected by the interest rate movements in the country.

These are some of the best debt funds available - 

(Data as of 7 November 2022)

Disclaimer: The securities quoted are exemplary and not recommendatory. Past performance is not indicative of future returns

These are some of the best liquid funds available - 

(Data as of 7 November 2022)
Disclaimer: The securities quoted are exemplary and not recommendatory. Past performance is not indicative of future returns

How to invest in mutual funds with the best research tools at your disposal? 

Compare various parameters between different mutual funds and choose the best one that suits you. Click here to start!

Conclusion

Debt funds and liquid funds are two of the mutual fund investment options available to investors. However, there is no thumb rule when deciding which is best. Investors can choose a particular fund based on the investment horizon, risk, returns, tax benefits, and liquidity they want to achieve.

This is not an investment advisory. The blog is for information purposes only. Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements, risk tolerance, goal, time frame, risk and reward balance, and the cost associated with the investment before choosing a fund, or designing a portfolio that suits your needs. The performance and returns of any investment portfolio can neither be predicted nor guaranteed.