Investing has always been a key to procure benefits and generate an extra source of income. People tend to invest their savings for different reasons – financial security, financial independence, wealth creation or attaining specific goals. Though the intention of investors has remained the same, the investment vehicles have changed over the years from traditional fixed deposits to the likes of mutual funds, stock, bonds.
Below is a concise representation & comparison of two popular asset classes:
Fixed Deposits (FDs)
When it comes to investing, safety of capital attitude is important to most investors. In India, fixed deposit or term deposit has been the most popular investment instrument over decades. It loved alike by conservative and risk-averse investors.
Fixed deposits are instruments offered by banks and other NBFCs (non-banking financial corporation) where a fixed amount of money is invested in a bank with a lock-in period & a pre-determined rate of interest.
Key features of FDs
- It is a one-time investment option for a short or long tenure
- They offer higher rates of interest than a savings account
- They have fixed lock-in period with a predetermined rate of interest
- The returns are fixed, stable and predictable
- Usually FDs do not offer liquidity, but still can be withdrawn before the period of maturity Your bank may levy a penalty if you close your FD prematurely
Liquid funds are a category of debt mutual funds which invest your money in money market securities like government securities, certificate of deposits, treasury bills, commercial papers and term deposits. Lower maturity period (mostly of 91 days) is the best of part of this asset class. This means the assets invested are not tied up for a long period of time as liquid funds do not have a lock-in period.
Key features of Liquid Funds
- Liquid mutual funds have no lock-in period
- Liquid funds have no entry or exit loads
- Withdrawals from liquid funds can be made within 24 hours on working days
- Liquid funds have the lowest interest rate risk among the debt funds as they primarily invest in fixed income securities and have short-term maturity
Safety of capital – Liquid Funds v/s. Fixed Deposits
While liquid funds have an edge over FDs in terms of tax-adjusted returns and liquidity, FDs have always been able to hold massive popularity due to strong safety.
To get a better understanding of the risks involved in liquid funds, we first need to understand how liquid funds work. They are open-ended short-term debt mutual funds that invest in money market securities like CDs, treasury bills, commercial papers and term deposits. Investing in liquid funds does carry a certain amount of risk associated with market volatility. As the investments are market linked, yields and the value of investment fluctuate. Liquid funds might also be subject to interest rate risk and credit risk.
- Interest rate risk Interest rates and bond prices are closely related. Being inversely proportionate, when interest rates go high, bond prices go down and vice versa. This prevailing interest rate changes affect bond pricing which in turn causes the NAV (net asset value) of the liquid fund to fluctuate. As liquid funds invest in low tenure debt instruments, interest rate risk is negligible.
On the other hand, interest rate on FDs is predetermined and not governed by market volatility neither subjected to fall in the interest rates. So the returns are fixed, stable and guaranteed.
- Credit risk: Bank fixed deposits and savings accounts are insured, but liquid mutual funds are not. Deposit Insurance and Credit Guarantee Corporation (DICGC) is liable to provide Rs 1 Lac to the investors for both principal and interest amount held by them (in case of default). Even though liquid funds invest in high-quality securities and seek to preserve principal capital investment, the risk does exist and is inevitable. The decline in the credit ratings would cause bond pricing and ultimately the NAV of the liquid fund to decline as well.
- Inflation risk: Long-term tenures are directly subjected to inflation risk, but since the liquid funds are short-term debt instruments, inflation risk is almost negligible to low.
Fixed deposits offer guaranteed and fixed returns. On the other hand, liquid funds can be perceived as low risk-relatively higher return instruments. Favorable market conditions may trump the traditional bank FDs. Ultimately, it is the risk appetite of the investor which would govern the choice.