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.

Volatility

• 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.

Credit Risk

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.

Liquidity

• 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.

Long-Term Returns

• 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.