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!
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
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
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)