Liquid funds vs debt funds - What is the difference?

As per AMFI, The mutual fund industry in India has witnessed exponential growth, with assets under management (AUM) surpassing Rs. 53.4 lakh crore in FY 2024, a 35% increase from the previous year. Among the various categories of mutual funds, liquid funds and debt funds can be suitable choices for investors seeking stability, liquidity, and a predictable return potential. However, it is important to understand the difference between debt and liquid funds before investing. Read on to learn more.

Table of contents

• What are liquid funds?
• What are debt funds?
• Differences between debt funds and liquid funds
• Tax Incidences of liquid funds vs debt funds
• Debt vs liquid funds - Which one is suitable for you?
• Factors to consider before investing in liquid or debt funds

What are liquid funds?

Liquid funds are a type of debt mutual fund that invests in short-term money market instruments with a maturity of up to 91 days. These include Treasury Bills (T-Bills), Commercial Papers (CPs), Certificates of Deposit (CDs), and other high-quality debt securities. The primary goal of liquid funds is to provide high liquidity, stability of capital, and a slightly better return potential than savings accounts.

Key features

• Maturity profile: Securities mature within 91 days.
• Liquidity: High; redemption is usually processed on a T+1 basis (next business day). Some funds even offer instant redemption.
• Risk level: Low due to short maturity periods and high-quality investments.
• Returns: Typically higher than savings accounts but lower than other long-term debt funds.
• Ideal use case: Parking surplus funds or maintaining an emergency corpus.

For example, if you have idle cash that you may need in the near term, a liquid fund can give you access to a better return potential than a savings bank account without compromising liquidity.

What are debt funds?

Debt funds are mutual funds that invest in a mix of fixed-income securities such as government bonds, corporate bonds, money market instruments, and other debt-related securities. These funds aim to provide a stable return potential while managing risks like interest rate fluctuations and credit quality.

Key features

• Maturity profile: Varies widely from short-term (a few days) to long-term (several years).
• Risk level: Moderate; depends on the type of securities held (e.g., government bonds are more stable than corporate bonds).
• Returns: Generally higher than liquid funds but with relatively more volatility.
• Types of debt funds
  • Short-Term Funds
  • Ultra-Short-Term Funds
  • Medium-Term Funds
  • Gilt Funds (invest in government securities)

Debt funds can be suitable for investors seeking a steady income over a medium-to-long-term horizon.

Differences between debt funds and liquid funds

Feature	Liquid Funds	Debt Funds
Maturity profile	Up to 91 days	Ranges from a few days to several years
Risk Level	Relatively Low	Moderate (depends on maturity and quality of underlying securities)
Returns	Lower than debt funds	Higher but more volatile
Liquidity	High; T+1 or instant redemption	Moderate; redemption may take 2–3 days
Investment horizon	Short-term (days or weeks)	Medium-to-long-term (months or years)
Taxation	Gains taxed based on applicable tax slab	Similar tax treatment

Tax Incidences of liquid funds vs debt funds

Liquid funds are a type of debt funds and therefore both are treated similarly for taxation purposes.

Investment made after April 1, 2023

The 2023 Union Budget made significant changes to the taxation structure for debt mutual funds. For all units purchased after April 1, 2023, all capital gains are considered short-term capital gains and taxed at the investor's slab rate, irrespective of the holding period,

Dividends are also taxable as per the slab rate.

Debt vs liquid funds - Which one is suitable for you?

Choosing between liquid funds vs debt funds depends on your financial goals, risk tolerance, and investment horizon.

1. Choose liquid funds if

• You need high liquidity.
• You want to park surplus cash temporarily.
• You seek low-risk investments that prioritise preservation of capital.

2. Choose debt funds if

• You have a medium-to-long-term investment horizon.
• You aim for higher returns and can tolerate moderate risk.
• You want diverse exposure to fixed-income securities.

Factors to consider before investing in liquid or debt funds

1. Investment horizon

• For short-term needs (up to 3 months), liquid funds can be suitable.
• For medium-to-long-term goals, opt for debt funds.

2. Risk appetite

• Liquid funds carry minimal risk due to short maturities.
• Debt funds involve credit risk, interest rate risk, and liquidity risk.

3. Liquidity needs

• If you require quick access to your money, liquid funds are better suited.

4. Expense ratio

• Check the expense ratio as it impacts overall returns; liquid funds typically have lower expense ratios compared to actively managed debt funds.

5. Credit quality

• Assess the credit rating of underlying securities in both fund types.

Conclusion

While the choice between liquid funds vs debt funds depends on your financial goals and investment horizon, one crucial but often overlooked factor is the role of market conditions in determining fund performance. For instance, during periods of rising interest rates, liquid funds tend to perform better due to their short maturity profiles, which allow them to reinvest in higher-yielding instruments quickly. Conversely, debt funds, especially those with longer durations, may experience a decline in returns due to the inverse relationship between bond prices and interest rates. This dynamic highlights the importance of timing and understanding macroeconomic trends when investing in either fund type.

FAQs:

What are the disadvantages of liquid funds?

Liquid funds, while low-risk, come with certain limitations. They offer limited growth potential due to their short investment horizon and focus on high-quality, low-yield instruments. As a result, their returns may not significantly outpace inflation over the long term.

Is it good to invest in debt-liquid funds?

Yes, investing in both debt and liquid funds can be beneficial, depending on your financial goals. Liquid funds are ideal for short-term needs or as a temporary parking space for surplus cash, offering better returns than a savings account with minimal risk. On the other hand, debt funds are suitable for medium-to-long-term investments where you aim for a relatively higher return potential and are willing to accept moderate risks. The decision ultimately depends on your risk tolerance and investment horizon.

Is a liquid fund taxable?

Yes, liquid funds are taxable. Liquid funds are taxed as per the investor's income tax slab rate, irrespective of the holding period.

What are the risks associated with investing in debt funds versus liquid funds?

Liquid funds carry minimal risks since they invest in high-quality securities with short maturities of up to 91 days. However, they are not entirely risk-free; factors like sudden credit downgrades or liquidity issues in underlying instruments could pose minor risks. Debt funds, on the other hand, have higher exposure to risks such as interest rate fluctuations, credit risk (default by issuers), and market volatility. The level of risk in debt funds varies based on the type of fund—for instance, gilt funds have minimal credit risk but are highly sensitive to interest rate changes.

How are expenses managed in debt funds versus liquid funds?

The expense ratio plays a crucial role in determining the net returns from both liquid and debt funds. Liquid funds generally have lower expense ratios because they require less active management due to their short-term investment horizon and predictable nature of underlying securities. Debt funds, however, may have higher expense ratios as they may involve active portfolio management to optimise the risk/return profile across varying market conditions.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.