Fixed Deposits and Liquid Funds: How do they compare

Kolkata: Fixed deposits have earned the trust of the common due to a simple fact -- they offer stable, predictable returns. They are also liquid, which means FDs are quickly convertible to cash. In sheer numbers, FD depositors leave investors in other instruments far behind. Significantly, liquid funds are a type of mutual funds which offer comparable features. Though the returns are not fixed like FDs, liquid funds offer steady returns due to their investment profile. And as the name indicates, these funds can be quickly converted into cash.

In fact, liquid funds have a few points which are more convenient than fixed deposits. Fixed deposits have a lock-in period, which is known as maturity period. But liquid funds have a clear advantage over FDs in this respect. They don't have any lock-in or maturity period. Experts point out that in the mutual fund universe liquid funds are considered ideal for investors with a short-term investment horizon. It is important that an individual has a clear understanding about the two instruments before he/she puts in hard-earned money in these instruments.

Liquid funds are a category of mutual funds that typically invest in debt securities and/or fixed-income instruments among which are government securities, commercial paper, bonds and treasury bills. Liquid funds are also known as money market funds. Liquid funds invest in debt and money market securities with a maturity period of up to 91 days. If you have cash that will lie idle for a few weeks to a few months, you could consider liquid funds to park it. These are ideal for short-term goals. High liquidity, low volatility and capital preservation are the hallmarks of a liquid fund.

Liquid funds do not suffer from volatility unlike equity-oriented mutual funds, the NAV (net asset value) rises and falls with the direction of movement in the equity markets, and if they are sector specific -- big cap, or mid cap or small cap funds -- their NAV rises and falls with the movement of the stock movement in that particular sector.

Since managers of liquid funds usually invest in fixed-income securities with high credit ratings, liquid funds don't record major unforeseen losses or gains. If an investor takes care to scrutinise the credit-rating of the instruments in which the fund manager has invested, it will be an added layer of security. However, capital gains taxes are applicable in liquid fund gains depending on how long the investor holds on to the investment.

Fixed deposits are debt instruments where one invests a lump sum which earns a fixed rate of interest which is usually payable at the end of a predefined time period, known as the maturity period. The minimum maturity period of an FD is seven days while the maximum tenure is 10 years. Usually the deposit is locked for the given time period. If you withdraw the money from an FD before maturity, the bank or NBFC with which you have deposited the money will not pay you the full promised interest but would pay a smaller amount. It is precisely because of this feature of paying a penalty if you withdraw before the tenure ends that FDs are not ideal for building an emergency fund.

The interest rate a bank pays on fixed deposits is a function of mainly the key interest rate ie, the Repo Rate, which, in turn, depends on the rate of inflation etc. But the interest income of an individual is subjected to income tax. It is added to the annual income and taxed at the applicable rate. There are a few types pf fixed deposits: These are: cumulative and non-cumulative.

In the cumulative FD, the interest keeps accumulating in the account and the entire principal and interest amount is paid as a single lump sum when the fixed deposit matures. The that is earned each year on the instrument is automatically ploughed back in the FD and generates returns at the applicable rate of interest. In non-cumulative fixed deposits the interest earned can be paid to the depositor in a fixed, pre-determined frequency -- once a month, or once in three months or once in six months or even once in a year. It is suitable for those who need a regular interest income to meet their regular expenditure.