Liquid funds or short-term bond funds: Which one is right for you?

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New Delhi | Updated: June 26, 2018 2:07:37 AM

Investors who want to keep money for very short periods of time but want a higher interest than offered on savings account may invest in liquid funds.

Investors in India have traditionally been risk averse and tend to invest in bank deposits and fixed deposits of non-banking financial companies. The tendency of Indians is more towards capital preservation and their risk appetite seems to be low, especially if we exclude the top 15 cities.
Investors who are risk averse or want to keep a certain portion of their assets in fixed income bearing securities can invest in debt mutual funds. Debt funds, amongst themselves have different risk profiles, which allows investors to choose funds based on their risk appetite and return expectations in these funds.

Debt mutual funds

Investors in debt mutual funds are exposed to inherent risks such as interest rate risk, credit risk, illiquidity risk and market risk. Interest rate risks refers to the risk when prices of the securities purchased move up or down due to changes in macro-economic conditions like higher inflation, higher government borrowings, adverse effect on rupee due to higher current account deficit and other global market developments. Credit risk refers to the risk, when the securities which the fund is holding get downgraded or when there is a possibility of the issuer of the security defaulting in payment of principal or interest. Market risk refers to the risk when the underlying securities cannot be liquidated at the price at which it is valued, due to markets not being deep enough to absorb the sale of the securities.
The debt funds offered by mutual funds can be broadly classified into three categories based on the varying level of interest rate risk, credit risk and market risk. The funds are also classified on the basis of the holding period restrictions. Normally, funds have exit loads for different types of risk which is run by the fund house. Let’s look at the popular categories of debt funds.

Investors who want to keep money for very short periods of time but want a higher interest than offered on savings account may invest in liquid funds. These liquid funds invest in money market instruments which mature within 91 days. The underlying instruments have the highest short term rating which indicates the companies’ ability is very strong for payment of interest and principal. This reduces the probability of credit risk of the portfolio.

The portfolio of the fund has an average maturity of around 30 to 45 days, which reduces the interest rate risk too; longer the maturity of the portfolio, higher is the interest rate risk. The returns of the individual securities in the portfolio are generally slightly above the prevailing call money rates (Call money is a money market arrangement for overnight transactions between banks, and primary dealers). Investors in these funds may be getting a return close to the call money rates.

Bond funds

A variation of these funds is the Short Term Bond Funds, which has a portfolio maturity of one to two years. Bulk of the portfolio of these funds is generally invested in one to two year papers. The returns of these funds come from interest accruals. Investors in these funds are expected to stay for 3 to 6 months. These funds do have some amount of credit risks, the risk of downgrades due to expected change in companies’ profile as these investments are made for more than one year. Therefore, these funds are suitable for investors who want less interest rate volatility.
Investors can also invest in income funds, dynamic bond funds, or gilt funds. Income funds normally create a portfolio consisting of corporate bonds and government securities. These funds have an average maturity of 4 to 8 years, which exposes the investors to higher interest rate risks. The funds also have credit risk, the chance of downgrade in the corporate securities held in these funds. The funds also have some market risk owing to corporate securities held in the portfolio; these papers are relatively illiquid compared with government securities.

 

Source: Quantum Mutual Fund

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