Liquid funds vs Other debt funds – Differences you need to know about

Last Updated on April 30, 2020 at 10:22 am

There has been a lot of buzz in the recent weeks about debt fund returns.  For a few days, liquid funds had a (temporary) fall in NAV. Some have interpreted this to suggest that liquid funds are ‘unsafe’.  This (hopefully simple) article explains some nuanced differences between liquid funds and other debt funds.

About the author: This a guest post by S. R. Srinivasan, SEBI registered fee-only investment advisor.  Financially independent, he believes in numbers based insights. You can approach him for your financial needs via srinivesh.in

Readers may recall his earlier articles:  How I achieved financial freedom and became an Investment Advisor! and the second part:  Factors that helped me achieve financial freedom. He has also written a useful guide on the list of Mutual fund categories that you can avoid!

If you want to use debt funds for tax-efficiency, but are worried about the risks in them, this article can provide some helpful information to select debt funds with ‘low risk’.  See: What is the need for debt funds when we can invest in safe fixed income? Before we look at the nuances, let us establish some terminology.

The problem of the average: This is common sense, but it helps to establish a key point. The average is a useful concept – but it can not give a good idea of the underlying values. Here is a popular statement: Someone can put one of my legs in a freezer and another leg in a heated oven. On average, this should be comfortable!

Money market vs Bonds

This is not very clearly understood by many people.  The money market is a market section where ‘cash’ is borrowed for a short time – 1 day to a few months.  In most economies, the money market securities are considered ‘equivalent’ to cash.  Investopedia has this definition:  “The money market is part of the fixed-income market that specializes in short-term debt securities that mature in less than one year. Most money market investments often mature in three months or less. Because of their quick maturity dates, these are considered cash investments. Money market securities are issued by governments, financial institutions, and large corporations as promises to repay debts. They are considered extremely safe and conservative, especially during volatile times. ” The last statement can be a stretch, but comparatively money market instruments are considered more liquid than other debt instruments.  In India, these are some of the money market instruments:

• Collateralised Borrowing and Lending Obligations (CBLOs) – In simple terms, a promissory note for 1 to 14 days, but backed by a government security
• Treasury (Government) bills issued for 91 days, 6 months and 1 year – These are issued weekly by the RBI and can be traded
• Certificates of Deposits (CDs) – In simple terms, the bank has an FD for you and me,  and CD for mutual funds
• Commercial Paper – Issued by companies (including PSUs, financial institutions) to meet short term borrowing needs

Bonds or Debt Securities are usually issued for a term of 1 year or more.  In India, some names are Government Securities (G-Sec), PSU Bond, Non-Convertible Debentures, Perpetual Bond, etc.

For a quick view, please look at the portfolio – as reported in Value Research – for HDFC  Money Market Fund and HDFC Short Term Fund.

There would be little overlap in ‘Instrument Type’ between these funds.

Tenor, Maturity and Duration: Debt instruments (except perpetual bonds) have a date of maturity. A bond may have been issued in 2019 with a maturity of 3 years. A year later, its tenor – time to maturity – is 2 years. As explained in – the Basics of Debt Mutual Funds Explained for New Investors –  the tenor of the security is a factor in the price. Other things being equal, a bond with a longer tenor would have higher variations in price (and correspondingly yield) when the interest rates change.  Duration is a technical factor that combines the tenor, interest rate and price in a single number. There are many ways in which Duration can be calculated.  Macaulay Duration is the specific factor used by SEBI in India.

Differences between Liquid fund and Debt funds

1 Liquid funds have very specific tenor: SEBI categorizes debt funds into many categories.   There are many duration based categories.  These have 2 subtypes.

• Categories based on ‘Maximum’ time to maturity  – Overnight funds (1 day), Liquid funds (91 days), Money Market funds (1 year)
• Categories based on Macaulay duration – which is a kind of weighted average of maturity  – All other duration categories, including ultra short term, low duration, etc.

Many investors may Ultra Short Term funds as having ‘twice’ the duration of liquid funds. But this is not so. In a liquid fund, each and every underlying security should have a tenor of 91 days or less.  In an ultra short term fund, the Macaulay Duration, a kind of weighted average, is 6 months or less.  A UST fund can easily have bonds of much longer maturity – even years – while keeping the duration lower.

2 Liquid funds have a choice of Money Market instruments: While it is not a given, money market instruments can be seen to have lower credit risks than other debt securities. Overnight funds and Money Market funds have to use only money market instruments. The return from Overnight funds is close to the repo rate.  Money Market funds have a wide choice of securities. They are more sensitive to interest rate movements. See: ICICI Pru Money Market Fund Review: When & how to use it 

Per SEBI, Liquid funds can invest in money market instruments.  They can also invest in other debt securities whose residual tenor is 4 months or less. (For example, a liquid fund can now buy the famous June 2020 Vodafone bonds.)   Even among money market instruments, a majority are issued for 3 months or less. They are also issued very frequently.  As we saw earlier,  SOV rated T-Bills are issued every week.  This gives a lot of investment options for managers of liquid funds.

3 Some Liquid funds can lower most kinds of risks: It is obvious that liquid funds severely limit interest rate risk as they hold securities with a *maximum* tenor of 91 days. Many of the liquid funds lower the credit risk by choosing only money market instruments. Some of these further lower the credit risks by restricting themselves to very high credit quality T-Bills and PSU Commercial Paper. The two funds in  Handpicked List of Mutual Funds April 2020 (PlumbLine) do this quite explicitly.

Summary

• Since liquid funds have a maximum tenor requirement of 91 days, there is an upper limit on the interest rate risk
• A liquid fund that uses only money market securities further reduces the credit risks
• A liquid that uses only high-quality money market securities reduces the credit risk even further
• If you want to use debt mutual funds instead of fixed deposits, you do have options to minimize the risks