Why Debt Investors Choose Liquid Funds Over Government Bond Funds for Capital Protection

Debt investments come with their own set of risks, particularly credit and interest rate risks. While government bond funds and PSU bond funds may seem like safer and more attractive options due to their lower credit risk, the interest rate risk in these funds can still be substantial. This article explores why debt investors opt for liquid funds under the same fund house for better capital protection.

The Risks in Debt Investments

Debt investments, like any other financial instrument, come with their own set of risks. The two primary risks in a debt fund are:

Credit risk: This risk arises due to the potential non-return of bond principal. If the issuer fails to pay back the bond, the investor loses their investment. Interest rate risk: This risk is closely tied to changes in interest rates. It affects the value of debt securities, with the value moving inversely to interest rates. This risk is measured using modified duration, which indicates the sensitivity of the security's price to interest rate changes.

Interest Rate Risk in Government Bond Funds and PSU Bond Funds

While government bond funds and PSU bond funds might appear to be a safer option due to their low credit risk, they still carry significant interest rate risk, especially measured by modified duration.

When interest rates rise, the duration of these funds increases, causing the Net Asset Value (NAV) to fall. For example, 10-year constant maturity gilt funds have extremely high duration risk. This means that investors could experience substantial losses when interest rates rise, leading to a very nasty surprise.

The Benefits of Liquid Funds

Debt investors can mitigate these risks by choosing liquid funds offered by the same fund house. Let's explore the reasons why liquid funds stand out:

Short Maturity Period: Liquid funds invest in debt and money market instruments with a maturity of up to three months (91 days). This short-term nature ensures that the fund is not affected by interest rate volatility, as it has earned interest income and is not exposed to the fluctuations in bond prices. No Lock-in Period: Liquid funds do not have a lock-in period, allowing investors to redeem their funds whenever needed for more immediate needs or liquidity. High Credit Rating: These funds tend to invest in highly-rated instruments, which ensures a higher degree of safety and stability for the investor. Additionally, the NAV of the liquid fund primarily changes with the interest income received. No Exit or Entry Load: Investors do not have to pay exit or entry loads when dealing with liquid funds. However, a management fee (expense ratio) is charged to cover the operational and management costs of the fund. Fast Redemption: When investors redeem their funds, the return is credited to their bank account on the next business day, ensuring quick access to their funds.

Investors should bear in mind the potential risks of debt investments and the importance of capital protection. By choosing liquid funds, they can better manage interest rate risk and protect their capital.

Conclusion

For debt investors looking for capital protection, liquid funds offered by the same fund house can be a superior choice compared to government bond funds and PSU bond funds, even though these latter options carry lower credit risk. The unique characteristics of liquid funds, including their short maturity period, lack of lock-in, high credit rating, no exit or entry loads, and fast redemption, make them an attractive option for investors seeking to mitigate interest rate risk and ensure better capital protection.