Liquid funds or ultra short-term debt funds: What should you opt for?

Indian investors have conventionally been risk-averse and are more likely to invest in bank deposits and fixed deposits of non-banking financial institutions. Capital preservation seems to be on the priority list of most traditional investors. This eventually lowers their risk appetite as well. Such risk-averse investors can put their money in debt mutual funds. Debt funds, as we know, allows investors to choose funds based on their personal risk appetite and financial goals.

“There are several categories of debt funds that allow investors to pick funds based on their return expectations and risk appetite. At times there is a wrong belief among investors that the debt funds are as safe as bank FDs. That’s not true at all. All categories of debt funds carry risk. It’s only that the type and extent of risk varies for different debt fund types. Most debt funds are exposed to inherent risks like interest rate risk, credit risk, illiquidity risk and market risk,” said Dev Ashish, founder at StableInvestor.com and a Sebi-registered Fee-Based Investment Advisor (RIA).

Interest rate risk, credit risk and market risk are a few of the most common risks associated with debt mutual funds. Interest rate risks hint at price fluctuation of the securities purchased due to changes in macro-economic factors like inflation, government debt, higher current account deficit, etc. Credit risk occurs when the securities held by the fund is downgraded or there is a possibility of a payment default. Market risk, on the other hand, refers to a situation when underlying security cannot be liquidated at its valued price due to market constraints or volatility. Normally, people get confused between two popular kinds of debt funds on offer – liquid funds and ultra-short-term debt funds.

Liquid funds invest in debt and money market instruments with a maturity date of up to 91 days. On the other hand, ultra short-term funds invest in debt and money market instruments with maturity duration of the portfolio between 3 months to 6 months. Compared to liquid funds, ultra-short funds have a slightly higher risk profile. As a result, the average expected returns from this category are also higher.

“Investing in a liquid fund or an ultra short-term fund depends on the short term financial objective of the investor and the excess money that is available. Liquid funds are best for temporarily parking idle cash lying in a bank account for a few months. These funds generally give returns higher than a savings bank account. Ultra short-term funds are suitable for investing for a longer duration like 6 months or even more. These funds are best for saving money for short-term financial goals. Both types of funds can be part of one’s portfolio depending on the requirement of the investor,” Ashish asserted.

He also said that while both categories belong to the low-risk side of the debt fund varieties, one should never just pick funds based on their past returns or star ratings alone. Always go for funds with low credit and interest rate risks. It’s best to do proper due diligence before picking debt funds so that you do not end up taking unnecessarily risk with your investments.

After all, the purpose of debt investments is to be less risky. For all high-return requirements and risk-taking, one needs to invest in equity funds. Debt fund choices should be properly risk-managed.