If you want to park excess funds for a short time except in your savings account, then liquid funds are the best option you have. These are short-term debt funds with a maximum maturity duration of 91 days, ideal for investors with excess investable funds. As the name suggests, these are highly liquid funds that would earn higher returns than your savings account.
Let’s understand liquid funds in detail and why these should be in your investment kitty.
Understanding liquid funds
Liquid funds are short-term investment schemes that invest in short-term, fixed-income generating investment options like Treasury bills, commercial papers, and the like. The primary purpose of the liquid funds is to offer liquidity, and hence, the investments in the fund have a maximum maturity period of 91 days. The allocated proportion meets the fund’s objective. The fund manager ensures that the average maturity period of the scheme is three months. It reduces the sensitivity of the fund’s returns due to changes in interest rates, making it less vulnerable. As a result, the fund’s returns don’t experience too many fluctuations and create a low-risk investment option for investors.
Liquid funds are ideal for parking idle investable amounts – emulates the liquidity aspect of a bank’s savings account but earns higher returns. Moreover, there is no lock-in period. Hence, investors can use liquid fund schemes instead of their savings accounts to make higher returns.
Types of money market securities
Liquid funds invest in the following money market instruments.
Certificate of deposit (CD): These are fixed-term deposits issued by scheduled commercial banks. The only difference from the fixed deposit is, investors can’t redeem certificates of deposits before maturity dates.
Commercial papers: These are promissory notes issued by large corporations with very high credit ratings. These are unsecured investments issued at discounted rates and redeemed on maturity. The difference between the two is the return earned by investors.
Treasury bills (T-bills): these investment instruments are issued by the government of India to finance short-term needs with a maturity tenure of 365 days. These are risk-free investments backed by the sovereign and earn lower risk-free interest than other investment options.
Who should invest in liquid funds?
- Investors with an idle investable amount looking for a haven can park their funds in liquid fund schemes
- Investors with short-term investment goals
- Investors need time to decide the right investment option, looking for a temporary but liquid investment for their fund
Liquid funds generate returns in performance-based incentives, bonuses, and other forms of gains from selling capital assets. You can initially invest the corpus in a liquid fund and then set a systematic transfer to an equity fund of your choice.
Considerations before investing in liquid mutual funds
Investors interested in liquid funds must consider the following factors.
Risk: In liquid funds, the associated risk is less. The peril with mutual fund investing concerns fluctuating NAV, but liquid funds invest for the short-term, and hence, the value doesn’t get affected by changing rate of interest.
Returns: Historically, liquid funds have earned 7 to 8 percent returns against 4 percent on the savings account. Although the returns from liquid funds are not guaranteed, they have generated positive returns.
Cost: Compared to other investments, liquidity funds charge lower fees. It is called the expense ratio, and SEBI has fixed the upper limit for expense ratio at 1.05 percent of the investable amount.
Investment horizon: Liquidity funds hold securities that have a maturity of no more than 91 days. These are suitable to park additional funds for a short period and thus enjoy the full potential of the underlying securities. For an investment horizon of one year or more, you can consider ultra-short-term funds.
Financial goals: Liquid funds are a good option for creating emergency funds. These funds earn higher returns but don’t have early cancellation penalties like FD and are readily available in emergencies. Usually, redeeming liquid funds takes one working day.
Taxation: Capital gains tax applies to the returns earned from the investment, depending on investment duration. Since liquidity funds invest in debt instruments, gains made during the first three years is taxable under short-term capital gain. Beyond three years, long-term capital gain tax is applied.
For short-term gains, the tax rate applies per the income tax slab of the investor. Long-term gain is taxed at a flat rate of 20 percent after indexation. Similarly, dividends earned get added to the total income of the investor and taxed accordingly.
Because of high liquidity, liquid funds have become widely popular. Hence, you can now find the best liquid funds easily by searching them online. We hope this explainer has helped you understand liquid funds’ meaning and make an informed investment choice.