Gilt funds vs liquid mutual funds: Which is better?

Mutual fund investors often seek a balance between liquidity, relative stability, and potential returns. Gilt funds and liquid funds are two popular options. While both fall under the debt fund category, they cater to distinct investment needs. This article provides you with a comparison of gilt funds and liquid funds to help you understand their key features, advantages, and drawbacks and make informed investment decisions.

• Table of contents

1. What are liquid funds?
2. What are gilt funds?
3. Differences between gilt funds and liquid funds
4. Gilt vs liquid funds: Which one is better for you?

What are Liquid Funds?

Liquid funds are short-term investment options and are considered a suitable alternative to traditional savings accounts. However, unlike savings accounts, returns from liquid funds are not guaranteed.

Liquid mutual funds primarily invest in debt instruments with very short maturity periods, typically up to 91 days. Liquid funds aim to provide investors with easy access to their money while aiming to generate returns that surpass those offered by savings accounts.

So, you may think of liquid funds as a parking space for idle cash. It gives you the liquidity aspect of a savings account but with the advantage of potentially higher returns. They achieve this by strategically allocating investments across a range of short-term, fixed-income securities like treasury bills, commercial papers, and certificates of deposit.

The fund manager maintains the fund's liquidity by ensuring that the maturity of the underlying investments remains within the stipulated 91-day timeframe. This approach minimizes the fund's sensitivity to interest rate fluctuations, leading to relatively stable returns. Hence, liquid funds are considered a relatively low-risk investment option, particularly suitable for individuals or entities with surplus funds seeking short-term investment avenues.

Moreover, liquid funds have no lock-in period allowing investors to redeem their holdings whenever the need arises. This flexibility makes liquid funds a suitable choice for those who prioritize liquidity and are open to earning potentially higher returns than what traditional savings accounts offer at a higher risk than savings account.

What are Gilt Funds?

Gilt funds are also a type of mutual fund. They invest heavily in government securities, also known as G-Secs.

These securities are essentially debt instruments issued by the central and state governments to raise funds for various purposes, including infrastructure development and public expenditure. In this way, gilt funds offer investors a chance to participate indirectly in the government's borrowing activities.

A defining characteristic of gilt funds is their mandate to allocate at least 80% of their total assets to government securities. This substantial exposure to government debt makes them suitable for risk-averse investors due to the perceived low credit risk associated with these securities.

While there are different types of gilt funds catering to various investment horizons, the underlying principle remains the same: they aim to generate returns primarily through interest payments on the government securities they hold. However, it's important to note that the performance of gilt funds is closely tied to interest rate movements. When interest rates fall, the value of existing bonds tends to rise, benefiting gilt fund investors. Conversely, rising interest rates can lead to a decline in bond prices and potentially impact the net asset value (NAV) of gilt funds.

Therefore, investors considering gilt funds should be mindful of the prevailing interest rate environment and their own investment objectives. These funds are often favoured by those seeking relatively stable returns with minimal credit risk, particularly in scenarios where interest rates are expected to decline.

Differences Between Gilt Funds and Liquid Funds

While both gilt funds and liquid funds fall under the umbrella of debt mutual funds , they cater to distinct investment needs and exhibit key differences in terms of their underlying assets, risk profiles, and return potential.

Underlying Assets

The most fundamental difference lies in the nature of the securities they invest in. Liquid funds primarily hold short-term debt instruments with maturities of up to 91 days, such as treasury bills, commercial papers, and certificates of deposit. On the other hand, gilt funds focus exclusively on government securities issued by the central and state governments, with maturities ranging from short-term treasury bills to long-term government bonds.

Risk Profile

In terms of risk, liquid funds are generally considered to have a lower risk profile compared to gilt funds. The short maturity of their underlying securities makes them less sensitive to interest rate fluctuations, leading to relatively stable returns. Gilt funds, while carrying minimal credit risk due to their exposure to government debt, are more susceptible to interest rate risk. Their net asset value (NAV) can fluctuate significantly in response to changes in interest rates, particularly for funds holding longer-duration government bonds.

Return Potential

The return potential of these two fund categories also varies. Liquid funds typically offer moderate returns, often exceeding those of traditional savings accounts. However, their primary objective is to provide liquidity and stability rather than optimizing returns. Gilt funds, on the other hand, have the potential to generate relatively higher returns, especially in a declining interest rate scenario. However, their returns are not guaranteed and can be impacted by interest rate movements.

Investment Horizon

The suitable investment horizon for each fund type also differs. Liquid funds are ideal for parking idle cash for short durations, ranging from a few days to a few months. They offer quick access to funds when needed, making them suitable for emergency funds or short-term financial goals. Gilt funds, with their exposure to longer-duration government securities, are more appropriate for investors with a medium to long-term investment horizon.

Investor Suitability

Liquid funds are well-suited for risk-averse investors seeking liquidity and stability for their short-term investments. Gilt funds, while carrying low credit risk, are more suitable for investors with a moderate risk appetite and a longer investment horizon who are comfortable with potential fluctuations in NAV due to interest rate movements.

Gilt vs Liquid Funds: Which One is More Suitable For You?

The choice between gilt and liquid funds depends on your investment horizon and risk tolerance.

If you seek a relatively stable option for your surplus funds with readily available liquidity, liquid funds could be a suitable option. They offer a relatively stable return profile, suitable for short-term financial goals or parking funds temporarily.

If you have a longer investment horizon and are comfortable with potential volatility, gilt funds might be worth considering. They offer the potential for higher returns, especially in a declining interest rate environment. However, it's essential to acknowledge the inherent interest rate risk associated with these funds.

So, you can view investing in gilt funds as a strategic bet on interest rates moving downwards. On the other hand, liquid funds prioritize stability and immediate liquidity. The optimal choice depends on your individual investment objectives and risk appetite.

Conclusion

A well-rounded investment portfolio often includes a combination of both liquid funds and gilt funds. Liquid funds provide liquidity and gilt funds have the potential for long-term capital appreciation. An understanding of both these funds helps investors build a balanced portfolio. Investors should evaluate their risk tolerance, investment horizon, and financial goals before choosing between these two options.

FAQs

Are the returns on liquid and gilt funds completely risk-free?

No, the returns on liquid and gilt funds are not entirely risk-free. Liquid funds carry minimal risk due to their short maturity profiles, but their returns can still fluctuate slightly with changes in interest rates. Gilt funds, while backed by the government and having virtually no credit risk, are more susceptible to interest rate risk. Their net asset values can experience significant fluctuations if interest rates change.

Who should invest in liquid and gilt funds?

• Liquid Funds: Suitable for investors seeking short-term investment horizons (a few days to a few months), high liquidity and easy access to their funds, stability and minimal risk in their investments, and slightly higher returns than traditional savings accounts.
• Gilt Funds: Ideal for investors with medium to long-term investment horizons, moderate risk tolerance, expectation of falling interest rates, seeking potential for higher returns, compared to liquid funds, but willing to accept some volatility

What are the disadvantages of liquid funds?

• Relatively Lower Returns: Compared to other debt funds or equity investments, liquid funds generally offer lower returns.
• Not Suitable for Long-Term Goals: Due to their lower return potential, liquid funds are not ideal for achieving long-term financial objectives.

Who should invest in gilt funds?

Gilt funds are a good investment option for investors seeking a relatively less risky investment with relatively stable return potential. These funds are particularly well-suited for individuals nearing retirement, government employees, pensioners, and those who prioritise minimal impact on invested capital over high-risk, high-reward strategies.

Is investing in gilt funds safe?

Gilt funds, while less risky than equities, are not entirely risk-free. Interest rate fluctuations, among other market risks, can impact their Net Asset Value (NAV). Rising interest rates typically lead to a decline in gilt fund values, and vice versa. Therefore, while gilt funds are a relatively secure investment, it's crucial for investors to have a clear understanding of interest rate dynamics to optimise return potential. To estimate the potential returns on your investments in these funds, you can use an SIP return calculator and compare the results.

What is the right time to invest in gilt funds?

Gilt funds can be a suitable investment option in declining interest rate environments. A decline in interest rates typically leads to an increase in bond prices, which in turn positively impacts the Net Asset Value (NAV) of gilt funds. It's advisable to consult with a financial advisor to gain personalised advice based on prevailing economic conditions and individual financial objectives.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.