5investors can choose to invest in different mutual fund schemes to suit their risk appetite, financial goals, and investment horizon. People generally consider liquid funds and debt funds as different mutual fund categories. However, this is not the case.
Debt funds are a larger category of mutual fund schemes, which include overnight funds, liquid funds, duration funds, gilt funds, credit opportunities funds, etc. A liquid fund is a subset within the broader universe of debt funds.
Since debt funds encapsulate several other mutual fund schemes, the suitability of liquid funds and other debt funds is different for different investors.
Comparison: Liquid Fund vs Debt Fund
Below are the comparison parameters for debt vs liquid funds:
Investment objective
Liquid funds invest in debt and money market securities having maturity or residual maturity of up to 91 days only. In contrast, debt funds may invest in a wide range of debt and money market securities having varying durations and maturities depending upon the investment objective of the mutual fund scheme.
For example, short-duration funds invest predominantly in securities maturing in one to three years; low-duration funds invest largely in securities with maturity between six months to one year. Similarly, gilt funds invest in government securities across different maturities considering the prevailing interest rate scenario, whereas a Banking & PSU Fund invests predominantly in debt securities of banks, PSUs, Public Financial Institutions, etc.
Investment risk
With liquid funds, credit risk and interest rate risk are low due to lower portfolio maturity of these funds. They have predominant investments in sovereign and money markets for up to 91 days only. In contrast, other debt funds invest in securities across different maturities and credit profiles depending upon the investment objective of the respective debt fund.
The interest rate risk and credit risk vary depending on the composition of the investment portfolio. Nevertheless, the risk profile is higher in other debt funds except for overnight funds , which invest in debt and money market securities maturing on the next business day.
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Return
Liquid funds tend to generate consistent returns since the investment portfolio mainly includes fixed income generating securities with shorter maturity. Liquid fund returns are less volatile given the shorter maturity of the portfolio. In contrast, Debt mutual fund returns may fluctuate less to more depending on portfolio maturity, changes in interest rates, and the credit profile of the investment portfolio.
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Liquidity
Liquid funds provide better liquidity to the investment of short-term surplus funds. The redemption transaction for liquid funds is processed in a shorter turnaround time. The redemption proceeds are transferred to the investor’s bank account on the next working day if the transaction has been received before the cut-off time.
In contrast, the redemption proceeds of other debt funds are transferred in an ordinary course, which is generally on T+2/ T+3 basis. Thus, the investors may receive funds from liquid funds 1-2 days in advance compared to other debt funds. Liquid funds tend to provide better liquidity since they invest in short-maturity instruments of up to 91 days only, which are more liquid relative to high-maturity instruments.
However, the liquidity of other debt funds is a function of the residual maturity, credit profile and interest rate cycle.
Tax incidence of returns from liquid funds and other debt funds
Since liquid funds fall within the category of debt funds, the taxation on investments in liquid fund Liquid fund returns and other debt funds is the same.
As per current tax laws, if the investments in debt funds are held for 36 months or more, the capital gains accrued on such investments are considered as Long Term Capital Gains (LTCG). However, if the holding period is less than 36 months, Short-Term Capital Gains (STCG) are applicable. STCG on debt funds is taxable at the regular tax rates.
However, LTCG is taxed at 20% (plus applicable cess and surcharge) post indexation. Indexation increases the investment cost for the inflation prevailing over the period while calculating the taxable gains, thus taxing only the actual returns (net of inflation). Indexation refers to adjusting the cost of acquisition to the prevailing inflation over the years of holding, leading to an increase in the acquisition cost and hence reducing the capital gains accrued. Consequently, the effective taxable gains reduce to that extent.
Investors may choose between different debt funds depending on their financial goals, risk profile and investment horizon.
Liquid Funds vs. Debt Funds: Which Would Be Better for You?
Liquid funds and debt funds both have their pros and cons. In the end, it depends on the individual and what their financial goals are. These differences between debt fund and liquid fund will help investors make an informed decision on which fund to choose.
Disclaimer:
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the investment date.
