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Managing short-term surplus money can be challenging, especially when you want both safety and easy access. Liquid funds are designed for this purpose. They invest in short-term, highly liquid debt instruments, making them suitable for temporary parking of funds. These funds aim to provide stable, market-linked returns while allowing quick withdrawals, offering a practical alternative to keeping excess money idle in a savings account.
Key Takeaways
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Liquid funds invest in short-term debt instruments, helping reduce interest rate risk and maintain stability.
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They offer high liquidity with no lock-in, allowing quick access to funds when needed.
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Returns are market-linked and depend on short-term interest rates, not fixed or guaranteed.
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Taxation is as per the income tax slab for both capital gains and dividends.
Understanding Liquid Funds
Liquid funds are short-term investment schemes that invest in short-term, fixed-income generating instruments such as 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 fund manager ensures that, as per SEBI mandate, each individual security held in a liquid fund must have a residual maturity of no more than 91 days. As a result of this constraint, the portfolio's Macaulay Duration will also be well under 91 days, though SEBI specifies the 91-day limit in terms of individual security maturity, not as a separate Macaulay Duration ceiling.
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. They emulate the liquidity of a bank's savings account but may offer relatively better, market-linked returns. Moreover, there is no lock-in period. Hence, investors can use liquid fund schemes as an alternative for managing surplus funds, depending on their needs and risk preferences.
How Do Liquid Funds Work?
Liquid funds operate by investing in short-term, high-quality, and easily tradable securities. Recent SEBI guidelines have reinforced these characteristics of liquid funds, focusing on safety and liquidity.
Liquid funds are required to maintain adequate liquidity in line with SEBI guidelines, including holding a portion of assets in highly liquid instruments like cash or money market securities. This liquidity ensures they can promptly meet redemption requests from investors. These funds also follow SEBI-prescribed exposure limits to manage concentration and credit risk.
The primary source of earnings for liquid funds is the interest payments they receive from their debt holdings. Capital gains make up only a small portion of their income. This unique feature sets liquid funds apart from other investment options. Here's how they benefit from this structure:
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When interest rates in the market decrease, the prices of bonds rise.
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Conversely, when interest rates increase, bond prices fall.
This relationship is more pronounced in long-term bonds, meaning they are more sensitive to market yield changes. However, liquid funds exclusively invest in short-term securities. Consequently, their market value does not fluctuate significantly when market interest rates change. This characteristic results in liquid funds having minimal capital gains or losses. In an environment with rising interest rates, liquid funds may be relatively less affected compared to longer-duration debt funds because:
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Their interest earnings increase, and
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Their market values are only mildly affected by capital losses.
In financial terms, liquid funds are said to have very low interest rate risk, making them a suitable option for investors seeking stability and liquidity in their investments.
Features of Liquid Funds
Liquid funds come with certain basic characteristics that make them suitable for short-term investing:
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No entry or exit charges (in most cases): Liquid funds carry a SEBI-mandated graded exit load for redemptions within 7 days of investment. The load starts at 0.0070% on Day 1 and steps down each day, reaching 0.0045% on Day 6, with zero exit load from Day 7 onwards. These amounts are very small in absolute terms and should not be a deterrent for retail investors.
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Flexible investment amount: Investors can start with a small amount and increase it based on their needs, making it accessible for different budgets.
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Low interest rate sensitivity: Since the investments have very short maturities, changes in interest rates have a limited impact on the fund’s value.
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High liquidity: Units can usually be redeemed quickly, often within one working day, making funds easily accessible when needed.
Advantages of Liquid Funds
Liquid funds have several benefits for investors, such as:
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Low risk: Liquid funds prioritise capital safety and provide relative stability during interest rate fluctuations, making them a relatively low-risk choice.
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Steady returns: Liquid funds aim for stable returns, making them suitable for short-term financial goals.
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Diversification: They offer diversification by investing in a mix of debt instruments, spreading risk.
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Low cost: These funds are generally cost-effective, with comparatively lower expense ratios depending on the scheme.
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Flexible holding: Investors can hold their money for as long as needed, with easy entry and exit options.
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Quick redemption: Liquid funds process redemptions swiftly, typically within one working day, thanks to investments in highly liquid and low-risk securities.
Example of Liquid Funds
Consider two liquid fund options, Fund A and Fund B, both investing in similar short-term, high-quality instruments and offering comparable gross returns.
Now, look at the cost difference:
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Fund A has an expense ratio of 0.3%
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Fund B has an expense ratio of 0.9%
After adjusting for costs, the net returns may slightly differ:
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Fund A: around 5.7%
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Fund B: around 5.6%
Even a small variation in expenses can impact overall returns. In a category where returns are generally close, choosing a lower-cost liquid fund can help improve net outcomes over time.
Who Should Invest in Liquid Funds?
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Investors with an idle investable amount, looking for a relatively safe and liquid option, can park their funds in liquid fund schemes
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Investors with short-term investment goals
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Investors who need time to decide the right investment option and are looking for a temporary and liquid place to park their funds
Liquid funds primarily generate returns through interest income from short-term debt instruments, with limited contribution from capital gains. You can initially invest the corpus in a liquid fund and then set a systematic transfer to an equity fund of your choice.
Also read about: What is a Surplus Fund?
Why Should You Invest in Liquid Funds?
You may consider investing in liquid funds when you want a balance between safety and quick access to money. These funds focus on short-term, high-quality debt instruments, which helps reduce volatility. They also offer flexibility, as you can withdraw funds without long-term holding commitments. For short-term financial needs or temporary parking of surplus cash, liquid funds provide relatively stable, market-linked returns while keeping your money accessible.
When Should You Invest in Liquid Funds?
There are certain situations where it makes sense to invest in liquid funds, especially when you want safety along with quick access to your money. These funds are useful in the following scenarios:
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For short-term financial needs: If you have planned expenses in the near future, liquid funds can help you park money without locking it in.
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As an alternative to savings accounts: When idle cash is earning low interest, liquid funds may offer relatively better, market-linked returns with similar accessibility.
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During uncertain market conditions: If markets seem volatile and you prefer to wait before making long-term investments, liquid funds can act as a temporary holding option.
How Do You Invest in Liquid Funds?
To invest in liquid funds, you first need to complete a basic KYC process. After that, you can choose a suitable fund based on your investment horizon, risk comfort, and expected liquid fund returns.
Investments can be made either as a lump sum or through a systematic plan, depending on your preference. Once invested, you can track performance regularly and redeem units when needed, as these funds are designed for easy access and short-term use.
Step 1: Log in to your investment account using your registered credentials and complete the verification process.
Note: If you do not have an investment account, you can open one by completing the KYC process and submitting the required documents
Also read about: KYC Process for Demat Account?
Step 2: Choose the right fund for your needs and risk tolerance by considering these factors:
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Search for your preferred fund or explore available fund options based on your preferences.
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Review the fund's historical performance, tax implications, sectors, and stocks it invests in.
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Estimate potential returns using the calculator.
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Assess the fund's risk level and match it with your risk tolerance.
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Check the fund's ratings from reputable agencies (typically rated on a scale of 1 to 5).
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Consider the fund's expense ratio to understand the cost of investing.
Step 3: Once you've decided on the fund(s) to invest in, access your investment account and navigate to the mutual funds section, and locate your chosen fund. Ensure your selection aligns with your investment horizon and financial goals. At this stage, consider the following:
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Decide between a lump sum investment and a monthly SIP.
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Enter the investment amount and choose your preferred payment method (preferably UPI or net banking).
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For SIP investments, set up a mandate for hassle-free future instalments.
Directly From the Asset Management Company (AMC) Website
If you choose to go through a mutual fund distributor, you can choose between various funds and different investment plans all in one place. However, the AMC website provides only the funds offered by the asset management company.
Liquid fund redemptions are typically processed within one business day (T+1), depending on cut-off timings and fund policies. Some fund houses offer an instant redemption (Instant Access) facility under SEBI guidelines, allowing you to receive the redemption proceeds in your bank account within a few minutes of making the request. However, SEBI caps this at ₹50,000 or 90% of the investment value in that scheme, whichever is lower, per investor per day. Larger redemptions follow the standard T+1 processing timeline.
How Much Return Can You Expect From Liquid Funds?
Liquid funds typically invest in instruments with maturities of up to 91 days. These funds offer lower returns compared to debt funds like short-term funds, low-duration funds, and ultra-short-term funds.
On the other hand, liquid funds generally offer relatively higher, market-linked returns than overnight funds, which primarily invest in overnight securities. Under normal circumstances, liquid funds are expected to offer relatively better, market-linked returns compared to savings bank accounts.
Returns from liquid funds vary based on prevailing interest rates and are generally aligned with short-term market yields. Therefore, people often use liquid funds to temporarily park surplus funds while maintaining liquidity and earning market-linked returns.
Types of Money Market Securities
Liquid funds invest in the following money market instruments.
Certificate of Deposit (CD)
These are fixed-term tradable instruments issued by scheduled commercial banks and eligible select All-India Financial Institutions (as permitted by RBI). Unlike fixed deposits, certificates of deposit are tradable in the secondary market but generally held until maturity by investors.
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. They are issued at a discount and redeemed at face value. Returns arise from the difference between the issue price and the face value at maturity.
Treasury Bills (T-bills)
These investment instruments are issued by the Government of India in tenures of 91, 182, and 364 days. However, since liquid funds can only hold instruments maturing within 91 days, only 91-day T-bills are eligible for inclusion in a liquid fund's portfolio. These are considered low-risk investments backed by the sovereign, typically offering lower returns than other money market instruments.
Taxation on Liquid Funds
Liquid funds provide investors with opportunities to earn dividends and capital gains. Dividend income from mutual funds is taxable in the hands of investors as per their income tax slab. Capital gains earned by investors when redeeming units of a liquid fund are also taxable as per the investor’s income tax slab.
After April 1, 2023, any returns or profits earned on debt funds are subject to the tax rate as per the individual's income tax slab. This tax is calculated for both short-term and long-term capital gains.
Considerations Before Investing in Liquid Mutual Funds
Investors interested in liquid funds must consider the following factors.
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Risk: Liquid funds carry lower risk, as short-term investments make NAV less sensitive to interest rate changes.
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Returns: Returns from liquid funds vary based on market conditions and are generally aligned with short-term interest rates. Although returns from liquid funds are not guaranteed, they have historically delivered relatively stable returns.
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Cost: Compared to other investments, liquidity funds charge lower fees. It is called the expense ratio, and SEBI has prescribed limits on expense ratios, which vary based on the fund structure and assets under management.
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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.
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For an investment horizon of 3 to 6 months, you may consider ultra-short-term funds. For horizons of one year or more, low-duration or short-duration debt funds may be more appropriate, depending on your risk profile and return expectations.
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Financial goals: Liquid funds are a good option for creating emergency funds. These funds may offer market-linked returns and provide liquidity without strict lock-in requirements and are readily available in emergencies. Usually, redeeming liquid funds takes one working day.
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Taxation: Capital gains tax applies to the returns earned from the investment, depending on investment duration. Returns from liquid funds are taxed as per the investor’s income tax slab, regardless of the holding period.
For short-term gains, the tax rate applies per the income tax slab of the investor. Indexation benefits are not applicable, and all gains are taxed as per the income tax slab. Similarly, dividends earned get added to the total income of the investor and taxed accordingly.
Conclusion
A liquid fund can be a practical option for managing short-term surplus money without locking it away. It focuses on stability, liquidity, and easy access, making it suitable for temporary parking of funds or meeting near-term financial needs. While returns are market-linked and not guaranteed, they are generally more efficient than leaving money idle. However, investors should always consider their financial goals, risk comfort, and taxation before investing in any liquid fund, ensuring it fits well within their overall financial plan.
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