Liquid Funds Vs Debt Funds

Liquid Funds Vs Debt Funds

The main difference between liquid funds and debt funds is that liquid funds invest in very short-term debt instruments with maturities of up to 91 days, while debt funds invest in a mix of debt instruments across different maturities, ranging from short-term to long-term.

This article covers: 

What are Liquid Funds?

Liquid funds are debt mutual funds that invest in highly liquid money market instruments with a maturity period of up to 91 days. These funds are ideal for investors with a surplus amount of money and looking to park it for a short period without compromising on returns. 

Some of the well-known liquid funds in India include Reliance Liquid Fund, HDFC Liquid Fund, ICICI Prudential Liquid Fund, SBI Liquid Fund, and Aditya Birla Sun Life Liquid Fund.

Liquid funds are subject to short-term capital gains tax if the units are sold within three years of investment. The tax rate is based on the investor’s tax slab. Long-term capital gains tax is applicable if the units are sold after three years. The tax rate is 20% with the indexation benefit.

What is Debt Mutual Funds?

Debt mutual funds are mutual funds that invest primarily in fixed-income securities such as government bonds, corporate bonds, and money market instruments. These funds suit investors seeking steady returns and willing to bear moderate risk. 

Some of the well-known debt mutual funds in India include Kotak Bond Short Term Fund, HDFC Short Term Debt Fund, SBI Magnum Medium Duration Fund, and ICICI Prudential Medium Term Bond Fund.

If units of debt mutual funds are sold within three years of investment, short-term capital gains tax may apply. The tax rate is based on the investor’s tax slab. Long-term capital gains tax is due if the units are sold after three years. With the indexation benefit, the tax rate is 20%.

Liquid Funds vs Debt Funds: Which is Better?

Liquid funds have a short investment horizon and lower risk, while debt funds have a longer horizon and higher risk. Both offer liquidity, but liquid funds provide quicker redemption. Tax benefits differ, with liquid funds having better long-term capital gains treatment. Liquid funds invest in short-term instruments, while debt funds invest in a mix of debt instruments. Liquid funds offer stable returns with lower volatility compared to debt funds.

Factors Liquid funds Debt funds 
Tenure Less than 91 daysFew months to a few years
Risk Comparatively less risky than debt funds High level of risk 
Returns Offer less returns than debt funds Offer comparatively more returns than liquid funds 
Liquidity One can exit anytime without paying any charges Limitations on the frequency of redemption 

1. Liquid Funds Vs Debt Funds – Investment Horizon

Liquid funds have a very short investment horizon of up to 91 days, while debt funds have a longer investment horizon ranging from a few months to a few years.

2. Liquid Funds Vs Debt Funds – Risk

Liquid funds are considered low-risk due to their short investment horizon and high-quality underlying assets, while debt funds carry a higher level of risk as they invest in a mix of debt instruments across different maturities and credit ratings.

3. Liquid Funds Vs Debt Funds – Liquidity

Liquid funds offer high liquidity as investors can redeem their investments in a few hours, while debt funds may take a few days to a week to process redemption requests.

4. Liquid Funds Vs Debt Funds – Tax Benefits

Both liquid funds and debt funds are subject to capital gains tax. However, liquid funds may offer better tax benefits as gains made on investments held for over three years are considered long-term capital gains, which are taxed at a lower rate than short-term capital gains.

5. Liquid Funds Vs Debt Funds – Underlying Assets Involved

Liquid funds invest in very short-term debt instruments such as treasury bills, commercial paper, and certificates of deposit, while debt funds invest in a mix of debt instruments such as government securities, corporate bonds, and money market instruments.

6. Liquid Funds Vs Debt Funds – Stability of Returns

Liquid funds offer stable returns with lower volatility due to their high-quality underlying assets and short investment horizon. Debt funds may offer higher returns but may have a higher volatility due to the mix of debt instruments they invest in.

Factors to Consider Before Investing in Debt Mutual Funds

1. Historical Performance

Historical performance is an important criterion to consider when deciding between liquid funds and debt funds. It gives you an idea of how the fund has performed in the past and can help you predict how it might perform in the future. When comparing the historical performance of liquid funds and debt funds, it is important to look at their returns over different time horizons.

2. Expense Ratio

The expense ratio is the annual fee charged by the fund house for managing your investment. It is important to consider the expense ratio when choosing between liquid funds and debt funds, as it can significantly impact your returns.

Liquid funds typically have a lower expense ratio than debt funds, as they invest in low-risk short-term securities. However, it is important to note that not all liquid funds have the same expense ratio, and some may charge higher fees than others.

When comparing the expense ratios of liquid funds and debt funds, it is important to consider the fund’s overall returns. A fund with a higher expense ratio may still be a better investment option if it has consistently higher returns than a fund with a lower expense ratio.

3. Diversification

Diversification is an important factor to consider when choosing between liquid funds and debt funds. Diversification is the practice of spreading your investment across different types of securities to reduce risk.

Debt funds typically invest in various fixed-income securities such as government bonds, corporate bonds, and money market instruments. This diversification helps reduce the overall risk of the fund, as it does not rely on the performance of a single security.

On the other hand, liquid funds typically invest in money market instruments such as treasury bills, commercial paper, and certificates of deposit. While these securities are considered low-risk, they are not as diversified as those held in debt funds.

Best Debt Mutual Funds in India

Here is a table comparing the historical returns of the best debt mutual funds mentioned in the article:

Fund Name1-Year Return (%)3-Year Return (%)5-Year Return (%)Date
HDFC Short Term Debt Fund7.768.609.2931/01/2022
SBI Magnum Medium Duration Fund10.1210.809.6331/01/2022
ICICI Prudential Medium Term Bond Fund8.509.419.5231/01/2022
Axis Banking & PSU Debt Fund7.198.208.6931/01/2022
Franklin India Income Opportunities Fund9.609.208.5031/01/2022

(The above-mentioned returns are subject to market risk and may vary occasionally. It is advised to consult a financial advisor before making any investment decisions.)

Best Liquid Funds to Invest in India

Here is a table comparing the historical returns of some of the best liquid funds in India as of March 4, 2024.

Fund Name1-Year Return (%)3-Year Return (%)5-Year Return (%)
HDFC Liquid Fund – Direct4.285.356.02
ICICI Pru Liquid Fund – Direct4.315.366.01
Aditya Birla SL Liquid Fund-D4.215.255.89
Nippon India Liquid Fund-D4.225.255.89
Axis Liquid Fund – Direct4.255.295.92
L&T Liquid Fund – Direct4.225.285.92

(Past performance may or may not be indicative of future results. It is always advisable to consult a financial advisor before making any investment decisions.)

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Liquid Funds Vs Debt Funds- Quick Summary

  • Liquid funds invest in short-term, low-risk securities and are suitable for investors with a short-term investment horizon and low-risk appetite, while debt mutual funds invest in a range of fixed-income securities and are suitable for investors with a longer investment horizon and higher risk appetite.
  • When choosing between liquid funds and debt mutual funds, investors should consider their investment horizon, risk appetite, liquidity needs, tax benefits, underlying assets, and stability of returns.
  • Some of the best debt mutual funds in India include the HDFC Corporate Bond Fund, SBI Magnum Medium Duration Fund, and Axis Short Term Fund, while some of the best liquid funds to invest in include the Aditya Birla Sun Life Liquid Fund, ICICI Prudential Liquid Fund, and Nippon India Liquid Fund.

Liquid Funds Vs Debt Funds- Frequently Asked Questions

1. What is the difference between debt and liquid funds?

Debt funds primarily invest in fixed-income instruments like bonds, debentures, government securities, etc., with a maturity period ranging from a few months to years. These funds are relatively less volatile than equity funds and are considered less risky. On the other hand, liquid funds invest in short-term money market instruments with a maturity of up to 91 days.

2. What are the disadvantages of liquid funds?

  • One of the main disadvantages of liquid funds is that they are subject to interest rate risk, which means that if interest rates rise, the fund’s returns may decrease. 
  • Since the liquid funds are linked to the market, there is no guarantee that you will get back your principal amount. 

3. Is it good to invest in debt-liquid funds?

Debt liquid funds can be an excellent option for investors with surplus funds they do not require in the short term. These funds offer higher returns than savings accounts and are relatively safe as they invest in short-term debt instruments. 

4. Is liquid fund taxable?

Yes, liquid funds are taxable in India. Short-term capital gains (investments held for less than three years) from liquid funds are taxed at the investor’s applicable tax rate. Long-term capital gains (investments held for over three years) from liquid funds are taxed at 20% after indexation. Additionally, liquid funds are subject to Dividend Distribution Tax (DDT), which is currently at 28.84%. However, investors can avoid paying DDT by opting for the growth option instead of the dividend option.

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