­What are the key differences between liquid funds and debt funds?

Investors are often torn between multiple choices when making an investment decision. While the best way to choose among different investment instruments is to consider their investment goals, risk appetite, etc., several instruments are often similar and can be confusing to select.

Many types of mutual funds exist, but they’re often subsets of a broader mutual fund category. Take debt funds and liquid funds. It is easy to confuse the two as separate categories, but the reality is liquid funds are a subset of the broad debt mutual fund category.

For instance, investors are often confused between debt funds and liquid funds. This article covers how both are different and which one you should choose based on your investment goals.

 liquid funds and debt funds

1. Liquid fund vs debt fund: Investment horizon

A significant difference between liquid funds and debt fund is their investment horizon. Liquid funds generally have an investment horizon of up to 91 days. Different types of debt funds, on the other hand, have different investment horizons. An investor can choose to invest in a short-term, medium-term, or long-term debt fund, depending on their financial goals.

Short-term debt funds invest in securities with six months to one-year maturity. Medium-term debt funds have an investment horizon of 1-3 years, and long-term debt funds have a longer investment horizon.

2. Liquid fund vs debt fund: risk involved

Liquid funds and debt fund investments bring unique risks and challenges. But they have something in common: both debt and liquid funds are good options for investors who do not wish to take many risks. Despite being a subset of debt funds, liquid funds are less risky than debt funds since they have a shorter investment horizon. Other debt funds may have higher credit risk and interest rate risk than liquid funds.

3. Liquid fund vs debt fund: liquidity

The ‘liquid’ in liquid funds refers to the ease of liquidity of the funds. It is the ease with which you can convert non-liquid assets to cash. A fund that has higher liquidity can be converted to cash easily. Remember that liquid funds are open-ended mutual fund schemes that have an instant redemption feature, meaning you can redeem your funds anytime and exit the mutual fund.

Other debt funds take slightly longer for redemption which means you will not get your money instantly after putting in a redemption request.

4. Liquid fund vs debt fund: tax benefits

The tax benefits for investors remain largely the same for both liquid and debt funds since liquid funds are a sub-category of debt funds. If, as an investor, you hold your investments in debt funds for 36 months or more, Long Term Capital Gains (LTCG) tax will be levied. If the holding period is less than 36 months, Short Term Capital Gains (STCG) tax will be levied.

5. Liquid fund vs debt fund: underlying assets involved

An essential distinction between liquid and debt funds concerns the underlying assets involved. The underlying assets in debt and liquid funds are differentiated based on the investment horizon. Liquid funds generally invest in short-term securities such as treasury bills, commercial papers, certificates of deposit, and CBLO (Collateralized Borrowing and Lending Obligation).

Debt funds invest in these securities along with gilt funds, fixed maturity plans, monthly income plans, etc.

6. Liquid fund vs debt fund: stability of returns

Liquid funds have shown greater stability in their return rate than debt funds. This is because liquid funds have a short duration and are less affected by interest rate movements in the market. Since debt funds can hold securities for longer, they are likely affected by interest rate movements over the tenure.

Depending on your investment horizon and expected returns and benefits, you could choose either or both investment options. Debt and liquid funds offer significantly higher liquidity than other investment instruments in the market. However, you can opt for a liquid fund for shorter-term investments, while for longer tenures, you can choose other types ofdebt funds. Since liquid funds are a sub-category of debt funds, you may also consider other factors, such as projected returns, the risk involved, and your financial goals, while choosing a fund.

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