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Debt Funds vs. Liquid Funds: Which One Should I Invest? Research Team | Posted On Wednesday, November 27,2019, 04:51 PM

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Debt Funds vs. Liquid Funds: Which One Should I Invest?



Investors often categorize debt funds into a single investment tool. Most of the investors are unaware of how the different types of debt instruments can suit their investment requirements. In this article, we will try to analyze how liquid funds and debt funds can be used to suit your investment needs.

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What are Debt Funds?

Investing in debt securities is similar to giving a loan to the issuing entity. Debt mutual fund is investment instruments that invest in fixed income securities like corporate and government bonds, treasury bills, commercial papers, and other money market instruments. 

The main objective of Debt mutual fund is to provide interest income periodically that enables you to appreciate your invested capital. So the fundamental reason for such investment is to generate an interest income within short investment tenure.

See Also: Taxation of Debt Funds

What are Liquid Funds?

Liquid funds are mainly a category of debt funds that invest in securities that matures within 3 months. Liquid funds invest in instruments such as treasury bills, commercial papers, and other debt securities. These funds contain the lowest interest rate risk unlike other debt funds, the reason is liquid funds invest in fixed income securities that have short-maturities.

Liquid funds do not have restrictions on the lock-in period. Also, you can withdraw the invested amount which gets processed within a day and is directly transferred to your bank account. Another notable advantage of liquid funds is that they have no exit or entry load.

Debt Funds vs. Liquid Funds: Which One Should I Invest?

Both are ideal investment options for conservative investors who are not inclined to equity investments. However, when the choice is between debt funds and liquid funds you can assess your requirement based on the following points:

- Investment Horizon:

Debt funds must be selected based on the investment tenure and your financial goals. For a medium investment horizon ranging from 1 to 3 years, then you can go for short term bonds. If you want to invest for a slightly longer tenure, say 3 to 5 years then the dynamic bond fund can be a suitable option. Experts say that longer investment tenure can give more returns during a rising interest rate regime.

But if your investment horizon is less than a year then liquid funds are the most suitable investment for you. Liquid funds are meant to park surplus cash for a short tenure. Such investments can help you earn a slightly higher interest rate than a savings account while maintaining its liquidity.

See Also: Invest In Short Term Debt Funds

-Risk Ratio:

If we talk about debt funds, there are certain risks associated with it. They are known to suffer from credit risk and interest rate risk which makes then risky investment options than liquid funds that contain the lowest interest rate risk.

Liquid funds are known to provide high liquidity and are the least volatile among all debt instruments. This is because they have an extremely short maturity period. Additionally, liquid funds invest in investment options that are issued by entities with high credit ratings.

-Return on Investment:

As we know debt funds are fixed income securities, but even then they cannot offer fixed returns. This is because the NAV of debt fund fluctuates and it poses an interest rate risk. Debt funds are unsuitable if the overall interest rate is on the rise. But they are good investment options when the interest rate falls.

If we look at the past performance of liquid funds, it has consistently offered returns within a range of 7-9%. It gives you satisfactory returns on maturity and carries the lowest interest rate risk among all types of debt funds. Even though you cannot be 100% of the returns, liquid funds are known to provide positive returns on the maturity of the funds.

See Also: How to Choose a Liquid Fund in 2019 by Minimizing Credit Risk

Which Funds are Great?

Debt funds can be divided into several categories based on the investment horizon of funds and liquid funds are one of them. As such debt funds must be chosen by keeping in mind your investment objective and the time you want to remain invested. Therefore, the key differentiating factor of debt funds and liquid funds are the investment tenure of these instruments.

You can choose to invest in short-term debt funds or dynamic debt funds to optimize your returns over a longer investment period. But if your objective is to earn slightly higher returns on your surplus funds while maintaining its liquidity then liquid funds are ideal investment options for you.

Additionally, liquid funds are much safer as they are known to provide positive returns wherever redeemed unlike other types of debt funds where the returns are not guaranteed.

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