Difference Between Liquid vs Debt Mutual Fund

difference between liquid funds and debt funds

Investment management is a mind-boggling task that involves achieving a certain level of risk while striving to achieve specific financial objectives. Some of the most popular investment options that young investors opt for include liquid funds and debt funds. Both come under the fixed-income scheme and have lower risk than equity.

Liquid funds are money market instruments that maintain very high liquidity with relatively low risks. On the other hand, debt funds are generally better equipped with instruments suitable for medium and long-term goals.

Read this article to learn more about the difference between liquid funds vs debt funds to make the right investment decisions.

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What are Debt Mutual Funds?

Debt mutual funds are a mutual fund scheme that mainly invests in fixed-income securities. These securities can be government securities, bonds, treasury bills, commercial papers, certificates of deposit, or other money market instruments.

These funds are meant to offer low but steady income by earning interest on various debt securities to invest in and avoid capital erosion. They are most suitable for investors seeking a regular income but with lower risk. This is why debt funds are less risky than equity funds since they are less likely to experience high fluctuations.

What are Liquid Mutual Funds?

Liquid funds are mutual funds that offer high liquidity, fund safety, and fixed income to investors. They invest mainly in money market instruments, including treasury bills, commercial papers, certificates of deposit, and other money market securities, mainly with a maturity of up to 91 days.

Liquid funds aim to provide a safe place for investors to park their excess money, offering better returns than a savings account with low risk. These funds are popular among investors due to their safety and predictability.

Key Differences Between Liquid Funds and Debt Funds

Understanding the main differences between liquid and debt funds will help investors choose the right option based on their financial goals and flexibility needs. Here's a breakdown of the key differences:

Aspect Liquid Fund Debt Fund
Definition A mutual fund investing in short-term money market instruments with a maturity of up to 91 days. A type of mutual fund that invests in various fixed-income securities like bonds, debentures, and government securities with varying maturities.
Investment Horizon Ideal for very short-term needs, typically a few days to 3 months. Suitable for short to long-term investments, ranging from a few months to several years.
Risk Level Very low risk due to short maturity and high-quality instruments. Low to moderate risk depends on the types of debt securities held and their maturities.
Returns Relatively lower returns than other debt funds but higher than savings accounts. Potentially higher returns than liquid funds due to a broader range of securities and longer investment duration.
Liquidity Highly liquid with easy redemption (usually processed within 24 hours). Less liquid than liquid funds; redemption may take 1-3 business days, depending on the fund.
Maturity Period of Instruments Up to 91 days. Varies from a few months to several years based on the fund type.
Types of Instruments Treasury bills, commercial papers, certificates of deposit. Corporate bonds, government securities, money market instruments, and debentures.
Risk Factors Minimal risk with negligible interest rate risk and default risk. Slightly higher risk due to interest rate fluctuations and credit quality of instruments.
Objective Capital preservation and high liquidity for short-term needs. Wealth creation and income generation for medium to long-term financial goals.
Interest Rate Sensitivity Very low due to short maturity. Higher sensitivity depends on the duration and type of instruments used.
Taxation (Short-term) Gains are taxed as per the investor's income slab if held for less than 3 years. Gains are taxed as per the investor's income slab if held for less than 3 years.
Taxation (Long-term) They are treated as short-term since they are rarely held for long. Gains held for more than 3 years are taxed at 20% with indexation benefits.
Exit Load Usually, there is no exit load after 7 days. There may be exit loads based on the fund type and investment duration.
Ideal For Emergency funds, parking surplus cash for short-term goals, and corporate cash management. Medium to long-term financial planning, steady income generation, capital appreciation.
Suitability Conservative investors seek safety and liquidity. Investors are willing to take slightly higher risks for better returns over time.

Factors to Consider Before Investing in Liquid & Debt Funds

Even though both liquid funds and debt funds fall under the fixed-income category, they are utilised for different investment activities. Before investing in any investment options, you must consider certain factors.

Factors Factors to Consider Before Investing in Liquid Funds Factors to Consider Before Investing in Debt Funds
Investment Horizon Liquid funds are required for a very short duration, usually from a few days to a maximum of three months. It can be used temporarily to invest funds in the near term of employment or to maintain cash emergency funds. Debt funds meet short-term, medium-term, and long-term requirements; select the fund carefully, as long durations can increase market risk.
Liquidity Needs Money invested in liquid funds is highly liquid, and redemption can be done within the shortest time possible, within 24 hours. Make sure the fund is easily withdrawable, especially if you are using it in areas of emergencies or operations. Liquidity in debt funds can vary depending on the specific fund, and some may have exit loads or restrictions on withdrawals.
Returns Expectation Returns are generally moderate, higher than that on a savings account, but lower than on most other funds. Understand that returns are associated with short-term money market instruments and may vary marginally. Debt funds offer relatively stable returns but fluctuate depending on interest rates and market conditions.
Expense Ratio The expenses for managing liquid funds are lower than those of debt funds because they undergo minimal fund management activities. Look at the expense ratio, as it can minutely affect the overall returns. Due to active portfolio management, debt funds typically have a slightly higher expense ratio than liquid funds. Consider the impact on returns.
Lock-in Period and Exit Load Liquid funds have no lock-in period, allowing easy access to funds. Some debt funds have exit loads if the investment is withdrawn before the specified period. Check the exit load structure to avoid additional fees.

Liquid Funds or Debt Funds - Which is Better?

Always remember the investment horizon, liquidity, returns, and risk when choosing between liquid and debt funds. Here's a breakdown of how you might prefer one over the other depending on your financial goals:

1. Investment Horizon

Liquid funds are best for short-term investment, which takes a few days to three months, so this is ideal for temporary needs. Debt funds cater to short-, medium-, or long-term goals, depending on the investor's needs.

2. Liquidity

Liquid funds provide reasonable liquidity and can be redeemed within 24 hours; this is ideal for emergencies. Debt funds are less liquid; some charge an exit load and have restrictions on withdrawal, restricting fast redemption.

3. Returns

Liquid funds have moderate returns. They are always higher than those of savings accounts but lower than most other investments, considering that they are short-term in nature. Debt funds offer better returns but fluctuate with the market.

4. Risk Level

Liquid funds carry minimal risk because they invest in short-term, high-quality debt instruments that are stable. Debt funds are less risky than equities but can be volatile, particularly with longer-duration investments.

In conclusion, liquid and debt funds are two different types of investment products possessing utility that meet investors' other financial objectives and risk-taking capacities. Making a good, informed decision will assist you in achieving the twin goals of meeting your short-term risk diversion needs and attaining your long-term goal of accumulating wealth.

Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.

We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.

FAQs about Liquid Funds vs Debt Funds

Is income from liquid funds taxable?

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Yes, income from liquid funds is taxable. If held for under three years, it is treated as short-term capital gains and taxed at the investor's applicable income tax rate.

Is it good to invest in debt funds?

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Yes, investing in debt funds can be a good option for conservative investors seeking stable returns and capital preservation. They offer several benefits, including regular income, diversification, and lower risk than equity funds.

How long should you invest in a liquid fund?

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You should invest in a liquid fund for a short duration, ranging from a few days to up to three months.

What is the lock-in period of debt funds?

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Debt funds generally do not have a lock-in period, allowing investors to redeem their units anytime.

Can liquid funds be riskier than debt funds?

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Yes, liquid funds are relatively safer than other mutual funds, and they are also not immune to occasional credit defaults or extreme market volatility.

Why do debt funds have interest rate risk while liquid funds do not?

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Debt funds invest longer than other securities, such as bonds, and act according to the market interest rates. Given these measures, liquid funds with relatively shorter maturity do not exhibit such sensitivity.

Can liquid funds lose money?

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While such exposure is not typical, liquid funds can be wiped out in financial crises or defaults by the issuer of securities held by the fund.

What is the basic difference in taxation in liquid and debt funds?

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over 3 years, the held investments can be indexed according to inflation, thus lowering the tax.

What is the holding period for liquid and debt funds?

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Liquid funds with lower-risk profits are suitable for investments that will need to be used in periods between up to 3 months, while duration-wise, debt funds can be selected as short-term, medium-term, and long-term.

Can we rebalance a portfolio with liquid funds?

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Yes, liquid funds are preferred for short-term work when shifting from one asset to another during rebalancing.

What is the difference between liquid funds and debt funds?

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Liquid funds invest in short-term instruments with high liquidity and low risk, while debt funds invest in longer-term debt with higher returns and slightly more risk.

Which is better, liquid funds or debt funds?

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Liquid funds are better for short-term liquidity and safety, while debt funds are better for medium to long-term growth with moderate risk.

Why choose liquid funds over debt funds?

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Liquid funds offer higher liquidity and lower risk and are ideal for short-term investments or emergency funds.

Can I invest in liquid funds or debt funds?

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Yes, both are available for investment; liquid funds are suited for short-term goals, and debt funds are for medium to long-term growth.

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Disclaimer

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  • This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
  • All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
  • Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.

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