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The financial market is an enticing platter of options for aspirational investors. There is always one instrument or the other that suits the specific requirements of an investor. Mutual fund investment is one such avenue tailor-made for investors looking at professional management and a diverse investment portfolio.
The mutual fund market is a large marketplace in itself, offering varied investments with different risk and return features. Today’s article talks about two funds – liquid and debt funds, along with their features and differences.
What are liquid funds?
Liquid funds, also called liquid debt funds, are a specific type of debt fund investing in debt instruments with high liquidity.
As the term suggests, these funds possess high degrees of liquidity and with a short-term maturity. A liquid fund is one that can translate to cash with ease. The matursity of liquid debt funds is usually up to 91 days, making this a suitable option for all those investors looking for short-term investment avenues.
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Such funds are chosen by fund managers when the objective is to conserve the investor’s capital while also providing a fair amount of return. Treasury bills, commercial papers, certificates of deposit, etc., are some common examples of liquid funds.
What are debt funds?
A debt fund, true to its name, is a type of mutual fund investing in debt instruments. These funds involve fixed-income securities that offer periodic income to investors in the form of interest.
Debt funds are similar to liquid funds with respect to the investment instrument. The difference is in the investment period. While debt funds are long-term, liquid funds are short-term fixed-income investments.
Government bonds, corporate bonds, debentures, etc., are investment options for a debt fund.
Liquid funds vs debt funds
Liquid and debt funds are ideal for those who want to maximise their wealth without high exposure to risk.
Liquid funds are ideal for those having excess cash and looking for an option to increase their value in the short term. Debt funds, on another hand, are suitable for investors with a long-term wealth generation perspective.
Debt funds, unlike liquid funds, do not possess high levels of liquidity. Hence, investors must be prepared to lock funds for a particular time period. A liquid fund provides quick liquidity and better returns against a savings bank account, making it a preferred option for short-term investors.
As for the risks involved, liquid funds are less risky as their maturity is limited. Hence, the opportunity for interest rate variations is limited, due to which credit risk is rare. However, default risk is an inherent risk associated with every debt instrument.
Debt funds are riskier since they participate in the market for a longer duration. They are more prone to interest rate fluctuations, which can reduce the bond’s value, affecting the overall fund’s NAV (Net Asset Value).
Difference between debt fund and equity fund
- Like a debt fund primarily invests in debt instruments, an equity fund majorly invests in stocks of different companies.
- A debt fund provides returns to its investors through periodic interest payments, while an equity fund allows capital appreciation and dividends.
- Equity funds are riskier since they invest in stocks, which fluctuate more than debentures and bonds.
- Debt funds work best for investors seeking stability in returns, while equity funds suit investors looking at growing wealth through capital appreciation.
Tax on liquid funds and debt funds
Liquid funds are eligible for short-term capital gains if they are sold within three years. The tax rate applicable is the same as that of their income tax slab. In rare cases where liquid funds are held for more than three years, a flat rate of 20% is applicable on long-term capital gains.
Debt fund taxation is similar, too. Short-term capital gains on investments held for less than three years are liable for tax as per income tax rates. Anything above three years will be taxed at 20% as long-term capital gains.
Bottomline
Both liquid and debt funds are ideal for investors who want a stable income with fewer risks. While liquid funds are more suitable for investors who do not want to lock their money for a continued period, debt funds serve the process of generating wealth over the long term.
These mutual fund schemes expose investors to lower risks as compared to stocks, making this a preferred choice among those looking for stability in the thrilling financial market.
FAQs
Liquid funds are safer than other short term options. However, they are not risk free. While the risk of interest rate fluctuation is rare, the risk of default or fall in credit rating can affect the value of the fixed income instrument.
Debt funds are relatively safer than stocks as their prices do not fluctuate like equities. However, there is seldom an option in the financial market that has no risk. Debt funds are exposed to credit risks and interest rate risks, especially in the long term.
The choice among the two depends on the investor’s risk and return expectation. Both FD and debt funds are safer than stocks. However, debt funds are still subject to a small degree of volatility. FDs are risk-free. Considering the returns, debt funds may offer higher returns than FDs.
Some top performing debt funds are:
Aditya Birla Sun Life Medium Term Plan Fund, Baroda BNP Paribas Credit Risk Fund, UTI Medium to Long Duration Fund, Nippon India Strategic Debt Fund, Sundaram Low Duration Fund, etc.
Some top performing liquid funds are:
UTI Liquid Fund – Direct Plan – GrowthLiquid, WhiteOak Capital Liquid Fund – Direct Plan – Growth, Nippon India Liquid Fund – Direct Plan – Growth, Bajaj Finserv Liquid Fund – Direct Plan – Growth, etc.