Liquid Funds vs Other Debt Funds – Differences
Tenor / Maturity
- Debt instruments (Except – Perpetual Bonds) have a fixed date of Maturity.
- The tenor of the security is a key factor in the Bond price. Bond with the longer Tenor would have higher fluctuations in the bond price because of interest rate changes.
- Each additional year in maturity adds some degree of volatility. However, the change in price is much smaller for the one-year maturity
- Liquid Funds:
- The Liquid funds have a Shorter Tenor.
- Liquid funds would typically invest in bonds / underlying security with a residual maturity of less than 91 days. Additionally, these securities are held up to Maturity.
Other Debt Funds:
- While Other categories of debt funds have Longer Tenor / Maturity.
- The maturity profile of underlying securities of debt fund varies greatly. Other Debt Funds can have bonds of much longer tenor or maturity – even years.
- As we discussed above, the debt part of the portfolio is to provide stability to the portfolio, not to generate a higher return.
- Protection of Corpus/Principal required in the near-term is a primary goal while investing in Liquid / Debt Funds. So, Volatility plays a major role in here.
- Thus, during the week periods of market volatility / uncertainty, Cash or Liquid Investments score over Other Debt Funds as far as Corpus Protection is concerned.
- Liquid Funds:
- In case of Liquid Funds, there is a limited Volatility due to Shorter Tenor. Returns on Liquid schemes fluctuate much less compared to other debt funds.
Debt Funds invest in non-government debt like commercial papers, Corporate bonds, Certificate of deposits among other instruments.
- If an issuer of a bond or commercial paper, held by the fund manager, fails to honor the repayment, the instrument will be downgraded.
- When the creditworthiness of the issuer is reduced, it has a bearing on the bond price too. Downgrading of the issuer will lead to a fall in bond prices which will, in turn, affect the fund’s net asset value.
- Liquid Funds: Lower Credit Risk
- In case of Liquid Funds, the probability of Credit risk / Default risk is very low due to short maturity of investment portfolio.
- The credit risk is further mitigated by investments based on evaluation of credit fundamentals such as outlook on the sector, parentage, quality of management and credit ratings.
- Many of the liquid funds lower the credit risk by choosing only money market instruments and by restricting themselves to very high credit quality T-Bills and PSU Commercial Paper.
- Other Debt Funds: Higher Credit Risk
- The other Debt schemes can have bonds of much longer tenor or maturity – even years, thus carry higher credit risk compared to Liquid Funds.
Interest Rate Risk
- Debt funds invest in bonds and debentures. The prices of these bonds are associated with benchmark interest rates.
- When the interest rates rise, the bond prices fall
- When interest rates fall, the bond prices rise
- However, the interest rate risk in case of liquid funds is negligible as liquid funds invest in very short maturity instruments.
- The bond’s yield on a price curve is steeper as the duration of the debt instrument increases.
- Liquid Funds: Lower Interest Rate Risk due to very shorter maturity instruments
- Other Debt Funds: Higher Interest Rate Risk due to Longer Tenor / Maturity
- In order to have higher returns, the debt funds proportionately take more interest rate risk than Liquid funds.
Inflation Risk / Inflation Protection
- The returns on all investments are vulnerable to inflation, since the higher prices reduce the purchasing power of the returns you earn.
- Inflation Risk is more of a derivative risk. When the price of things in an economy rises, RBI will be forced to increase the interest rates to make credit expensive.
- When interest rates rise, bond prices will fall. Falling bond prices will bring down the net asset value of the fund.
- Liquid Funds
- In order to meet the primary goals of liquid Funds – Stability (Lower Volatility) and Easy Liquidity, the Returns of Liquid Funds’ Investments can barely beat Inflation in the long-term.
- Other Debt Funds
- Because of the better returns, Debt Funds look better than Liquid Funds’ investments from the point of view of outgunning inflation.
- When investors park surplus money in Liquid funds or other Debt Funds for meeting contingencies, Liquidity is very important parameter to be considered.
- In short Liquidity means the Ease of Redemption as per the investor’s requirement.
- Liquid Funds
- As the name suggests, Liquid Funds 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 Debt Funds
- 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.
- After the recent Franklin Concern, the instant Liquidity / on-the-spot redemption of these 6 debt funds has become a great concern for their Debt investors.
- As far as Returns are concerned, Liquid Funds have only one stream of income Interest income while the other debt funds have 2 streams of income: Interest income and Capital Gains.