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While choosing to invest in mutual funds, there is often confusion for investors between debt funds and liquid funds. A debt fund is a broad mutual fund category that invests its collective pool of money in fixed income securities. In contrast, a liquid fund is a subset of a debt fund scheme. This article will discuss the difference between a liquid fund and a debt fund (liquid fund vs debt fund) in detail. 

What are Liquid Funds?

A liquid fund is an open-ended debt mutual fund that invests in debt securities with a maturity of fewer than 91 days. In simple words, a liquid fund is a subset of a debt mutual fund.  The fund portfolio invests in debt instruments that are of high credit quality. They invest in money market instruments like certificates of deposits (CD), treasury bills(T-bills) and commercial paper (CP) for up to 91 days. Unlike any other debt funds where the NAV of the fund is calculated only on business days, liquid funds NAV is calculated for 365 days. 

Liquid funds are highly liquid in nature and have no lock in period. In other words, this fund has no entry and exit load. Also, the risk associated with liquid funds is the least compared to other classes of debt mutual funds. Furthermore,  liquid schemes can give better returns than savings bank accounts. Therefore, individuals having idle funds lying in their bank account can park them in liquid funds to earn better returns. 

What are Debt Funds? 

A debt fund is a mutual fund scheme that invests in fixed income generating instruments with lesser risk and lesser volatility. Some of the fixed income instruments are Certificate of deposit, Corporate Bonds, treasury bills, commercial paper, government securities and many more. Debt funds are also known as Bond Funds or Fixed Income Funds. 

The major objective of debt funds is to provide regular and fixed interest during the investment period. Also, it aims for capital appreciation for an investor. Debts funds can be classified into various categories based on the maturity of the underlying securities of the fund portfolio. Some of them are liquid funds, ultra short term funds, gilt funds, income funds, corporate bond funds, dynamic bond funds, etc. 

The selection of assets for a debt fund is based on the credit rating. When the credit rating is higher, it gives a higher assurance that the interest payment is regular and the principal amount invested is repayable upon the maturity of the investment. Thus, these funds are a better option than the traditional investment options like bank deposits and savings bank accounts.

Liquid Fund vs Debt Fund

The following are the key parameters that show the differences between liquid funds and debt funds. 

Average Maturity

The first and most important difference that can be made between liquid funds and debt funds is the average maturity of the underlying securities. Liquid funds invest in fixed income securities that have a maturity period of 91 days. Also, these securities are held till the end of maturity. 

For debt funds, there is no restriction on the maturity term. The average maturity for the debt funds varies based on the fund category. Thus, the maturity profile of the underlying securities of the debt fund portfolio can be a combination of both short and long term instruments based on the fund’s underlying objective. 

Risk

Comparatively, the risk component in liquid funds is very low. The reason is, the average maturity tenure of the underlying securities is low. As a result, the interest rate risk and credit risk attached to these funds are also minimum. Also, the securities are held till the end of maturity instead of trading.

In the case of debt funds, they carry higher interest rate risk and credit risk. Hence, one must evaluate these funds before investing in them. 

Returns

The liquid funds have a shorter term, and hence the interest rate fluctuation is very less. Therefore, these funds tend to deliver stable returns. 

For debt funds, the returns of the fund fluctuate depending on the interest rate movements in the country. 

Liquidity

In comparison to other mutual fund schemes, liquid funds have liquidity. In other words, an investor can exit from this fund anytime without any charges. Also, many AMCs offer an option of instant redemption for liquid funds. Through this facility, investors can get their money in their bank account within 30 minutes from the time they place the order. 

Other categories of debt funds are not as liquid as liquid funds. Investors can get their maturity proceeds the next business day after placing the redemption request. 

NAV Determination

For liquid funds, the NAV is calculated for all 365 days. 

For debt funds, the NAV is calculated only on business days. 

Taxation

Since liquid funds are a part of debt funds, the taxation of liquid funds is the same as debt mutual funds. In debt funds, short term capital gains (STCG) arise if the holding period is less than three years. The capital gains are taxed as per the individual’s income tax slab rate. Similarly, long term capital gains (LTCG) arises when the holding period is more than three years. The capital gains are taxable at 20% with indexation benefit. 

Read also about the Liquid Funds vs Fixed Deposits

Conclusion

Both liquid fund and debt fund have their own merits and demerits. However, it finally lies on the individual on which fund to choose. This again depends on the individual’s financial objectives, investment horizon and risk tolerance level. Also, the fund objective should be in line with their objective. Therefore, one has to evaluate all these factors before investing in these mutual fund schemes. 

You may also like to read about the Ultra Short Term Funds vs Liquid Funds