Liquid/ Overnight Funds vs Other Debt Funds

A Comparative Analysis – Liquid Funds vs Other Debt Funds

Introduction

Have you built an adequate Emergency Corpus amid ongoing uncertainties due to COVID-19 crisis? A Comparative Analysis – Liquid Funds vs Other Debt Funds would help you decide which is a better option to build the emergency corpus. Protection and Safety of the Corpus and the Quick Liquidity are the two crucial parameters for the Emergency Fund.

Liquid Funds vs Other Debt Funds

• The primary role of debt part of the portfolio is to provide stability to the portfolio and not to generate a higher return. If investors want a higher return from their portfolio, they should ideally increase equity allocation in the portfolio.
• Lets discuss the Money Market Instruments and Debt Securities in detail.
• Money Market Instruments
  • 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 have maturity up to 91 days. 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.
  • Money market mutual funds invest in government treasury notes and treasury bills, as well as certificates of deposit.
  • Liquid funds invest in short-term fixed-interest-generating money market instruments like Commercial paper, Government Treasury bills, Call money, Certificate of deposits, Term-deposits etc.
• Debt Securities / Bonds
  • The Debt Funds buy Debt Securities from corporations and government agencies. Debt Securities are usually issued for a term of 1 year or more. 
  • In India, key Debt Securities are Government Securities (G-Sec), PSU Bond, Non-Convertible Debentures, Perpetual Bond.

A Comparative Analysis – Liquid Funds vs Other Debt Funds

Here, we are going to do a comparative analysis of Liquid Funds and Other Debt Funds based on the parameters as follows :

1. Tenor / Maturity

• Debt instruments (Except – Perpetual Bonds) have a fixed date of Maturity.
• The tenor of the security is a key factor in the Bond price. Bond with the longer Tenor would have higher fluctuations in the bond price  because of interest rate changes.
• Each additional year in maturity adds some degree of volatility. However, the change in price is much smaller for the one-year maturity
• Liquid Funds :
  • The Liquid Funds have a Shorter Tenor.
  • Liquid funds would typically invest in bonds / underlying security with a residual maturity of less than 91 days.(Overnight Funds invest in securities of maturity of only 1 Day).
  • In a liquid fund, each and every underlying security should have a tenor of 91 days or less.
  • So, their Average maturity is less than 91 days.
  • Additionally, these securities are held up to Maturity.
• Other Debt Funds :
  • While Other categories of Debt Funds have Longer Tenor / Maturity.
  • The maturity profile of underlying securities of debt fund varies based on the type of Debt Funds.
  • Their maturity is decided based the Macaulay Duration of complete portfolio, a kind of weighted average.
  • The Average Maturity of Liquid, Overnight and other type of Debt Funds is given below :

2. Volatility

• As we discussed above, the debt part of the portfolio is to provide stability to the portfolio, not to generate  a higher return.
• Protection of Corpus/Principal required in the near-term is a primary goal while investing in Liquid / Debt Funds. So, Volatility plays a major role in here.
• Thus, during the weak periods of market volatility / uncertainty, Cash or Liquid Investments score over Other Debt Funds as far as Corpus Protection is concerned.
• Liquid Funds :
  • In case of Liquid Funds, there is a limited Volatility due to Shorter Tenor. Returns on Liquid schemes fluctuate much less compared to other debt funds.
• Other Debt Funds :
  • Whereas, Debt funds have higher Volatility due to Longer Tenor / Maturity / Duration.
• Liquid or Money Market Investments offer an implicit guarantee of Principal Stability, whereas Other Debt investments don’t. 
• That means that volatility is a no-issue for liquid funds investors, whereas debt  investors may have to put up with a fluctuations in their principal.
• Standard Deviation is used to gauge the volatility of the fund :

3. Credit Risk

• Debt Funds invest in non-government debt like Commercial papers, Corporate bonds, Certificate of deposits among other instruments.
• If an issuer of a bond or commercial paper, held by the fund manager, fails to honour the repayment, the instrument will be downgraded.
• When the creditworthiness of the issuer is reduced, it has a bearing on the bond price too. Downgrading of the issuer will lead to a fall in bond prices which will, in turn, affect the fund’s net asset value.
• Liquid/Overnight Funds : Lower Credit Risk
  • Overnight funds have almost zero credit risk.
  • In case of Liquid Funds, the probability of Credit risk / Default risk is very low due to short maturity of investment portfolio.
  • The credit risk is further mitigated by investments based on evaluation of credit fundamentals such as outlook on the sector, parentage, quality of management and credit ratings.
  • It doesn’t mean liquid funds have zero credit risk.
    • IL&FS crisis did impact many Liquid Funds like Union Liquid Fund – About 3% impact in 2018
    • Ballarpur Industries Downgraded impacted 7% in 2017 on Taurus Liquid Fund
  • Many of the liquid funds lower the credit risk by choosing only money market instruments and by restricting themselves to very high credit quality T-Bills and PSU Commercial Paper.
• Other Debt Funds : Higher Credit Risk
  • The other Debt schemes can have bonds of much longer tenor or maturity – even years, thus carry a higher credit risk compared to Liquid Funds.
• The Credit Risk is the highest in case of Credit Risk Funds :

4. Interest Rate Risk

• Debt funds invest in bonds and debentures. The prices of these bonds are associated with benchmark interest rates.
  • When the interest rates rise, the bond prices fall
  • When interest rates fall, the bond prices rise
• However, the interest rate risk in case of liquid funds is negligible as liquid funds invest in very short maturity instruments.
• The bond’s yield on a price curve is steeper as the duration of the debt instrument increases.
• Liquid Funds : Lower Interest Rate Risk due to very shorter maturity instruments
• Other Debt Funds : Higher Interest Rate Risk due to Longer Tenor / Maturity
• In order to have higher returns, the debt funds proportionately take more interest rate risk than Liquid funds.

5. Liquidity

• When investors park surplus money in Liquid funds or other Debt Funds for meeting contingencies, Liquidity is very important parameter to be considered.
• In short, Liquidity means the Ease of Redemption as per the investor’s requirement.
• Liquid Funds :
  • As the name suggests, Liquid Funds offer easy redemption facility. Some AMCs offer instant redemption facility on liquid funds.
  • This means you can have the cash from liquidation of your units within 30 minutes into your account. 
  • Funds Offering Insta Redemption Facility :
    1. Nippon Liquid Fund – Growth
    2. ICICI Prudential Liquid Fund
    3. Axis Liquid Fund – Growth
    4. Aditya Birla Sun life Liquid Fund
• Other Debt Funds :
  • Other categories of debt funds are not as liquid. Maturity proceeds may take up to two working days to come to your account after having placed a redemption request.
  • After the recent Franklin Mutual Fund Issue – Closure of 6 Debt schemes, the instant Liquidity / on-the-spot redemption of these 6 debt funds has become a great concern for their Debt investors.

6. Returns

• As far as Returns are concerned, Liquid Funds have only one stream of income : Interest income while the other debt funds have 2 streams of income : Interest income and Capital Gains.
• The capital gains in debt funds are a result of interest rate (and therefore bond price) movements.
  • Due to the declining interest rates, the return differential between Liquid funds and Debt funds has grown even more clear in recent years.
  • Falling Interest Rates boost bond prices but at the same time depress interest income of Liquid Funds.
• In contrast with debt funds, which have the potential for appreciation as well as losses over an investor’s holding period, the return that Liquid funds investors earn consists strictly of yield ie. Interest income. There is no appreciation potential for Liquid Funds.
• Liquid Funds : Lower Long-Term Returns due to only 1 income stream ie. Interest
• Other Debt Funds : Higher Long-Term Returns due to 2 income streams –  Interest & Capital Appreciation
• Thus, the long-term returns of debt funds were solidly ahead of liquid funds investments
• However, amid the recent Liquidity crisis in the bond market, Franklin Crisis, Severe redemption pressure from the investors, the safer Liquid funds are looking as the consistent and stable investment product for near-coming goals, since the debt market is currently in a great turmoil.
• The Historical returns of Liquid, Overnight and Other Dent Funds is as follows :

Summary – Difference Between Liquid/ Overnight Funds & Other Debt Funds