Liquid funds are short-term debt funds that invest in assets like government bonds, treasury bills, etc. These have a maturity of up to 91 days. Investments in these funds are highly liquid, making them a suitable choice for parking surplus funds or emergency savings.
Liquid funds are debt funds that are invested in short-term assets. As per the SEBI regulations, liquid funds are only allowed to invest in money market securities and debt that has maturities of up to 91 days. These assets include government securities, treasury bills, certificates of deposit, repo, or commercial papers.
The market price of the securities held by the fund determines the return of a liquid fund. The prices of short-term bonds don’t change as much as those of long-term bonds. This makes the returns of the liquid funds to be more stable than other debt funds.
How do Liquid Funds work
Mutual funds in the category of liquid funds invest your money in debt instruments of a short-term nature. According to the regulations set forth by the Securities and Exchange Board of India (SEBI), liquid funds can invest capital in debt instruments with maturities reaching 91 days and money market securities only. Such assets comprise treasury bills, government securities, certificates of deposit, commercial papers, or etc.
The primary aim of liquid funds is to work in such a way as to provide you with the liquidity of capital. This is the main idea of short-term debt instruments as the main investments in such funds. The returns of liquid funds are largely dependent on the market value of the various securities that the fund holds. In terms of security in your investments, liquid funds may give your portfolio the stability it needs if you have other high-risk investments.
Features of Liquid Mutual Funds
Returns – Despite the likelihood of being affected by market conditions, liquid funds may offer a higher rate of return upon redemption. Historically, liquid debt funds have generated returns of around 7%-9%, quite higher compared to the returns of a savings account.
Financial goals – Liquid mutual funds can be considerably helpful when saving up for emergency funds. Besides giving higher returns than saving the capital in bank accounts, the best liquid funds also offer quick and easy liquidity when required.
Investment horizon – Liquid funds give you increased flexibility when it comes to the holding period/investment horizon. In case you want to set aside your emergency corpus in liquid funds, considering a longer tenure meets the purpose. In case you are considering liquid funds as temporary investments to hold surplus funds till you find the right option to invest your money in, you can consider a shorter horizon as you depending on your need.
Costs – As with all mutual funds, liquid funds also charge a small fee called an expense ratio to manage your funds. SEBI has mandated the upper limit for the expense ratio to be 1.05%.
Advantages of Liquid Funds
Low risk – The best liquid mutual fund is a low-risk debt fund that ensures securing the principal and offering steady returns. This causes the liquid funds’ cycle to be stable across diverse interest rate cycles. On the flip side, funds with longer-holding maturity securities may reap solid profits when rates drop or may end up making losses with the rates rise.
Low cost – As liquid mutual funds in India are not as actively managed, they are a low-cost debt fund compared to other variants. Most liquid funds even operate at an expense ratio of less than 1%. This low-cost structure offers the investor a promising return on their investment.
Flexible holding period – The investors of a liquid mutual fund may hold their investments for as long as they want. Though, there is a small exit load that may be charged for redemption within 7 days. However, its flexibility makes it an easy investment option to enter and exit while offering steady returns when holding the investments.
Quick redemption – Redemption requests are handled promptly, allowing for the request to be processed within one working day. Besides that, some funds even offer a much quicker redemption. This is possible as liquid funds are usually invested in highly liquid securities with a lower default possibility.
Risks involved in Liquid Funds
Interest rate risk – Interest rate risk arises as a result of the change in bond prices due to interest rate fluctuations. A high rate of interest results in a drop in bond prices, whereas a low rate of interest leads to high bond prices.
Inflation risk – Liquid fund returns are generally lower compared to other investment options, such as stocks and bonds, as per their safety and short-term nature. Due to this, the returns may not be able to beat the rate of inflation. This risk further increases with the bond maturity period.
Credit risk – Liquid funds aren’t insured like traditional savings and fixed deposit accounts. Despite investing in high-quality securities, risk in the market is still inevitable. This may lead to not getting the invested capital when redeeming the funds. When the issuer is not able to pay the principal or the interest on time, then the bond is considered to be in default. The prices of the issuer’s bonds or the NAV of the liquid fund are both likely to diminish if the credit rating or the issuer’s credibility diminishes.
Factors to Consider Before Investing in Liquid Funds
The factor of risk in any investment is one of the foremost things on people’s minds. The potential risk in mutual funds comes into the picture if there are potential fluctuations in the NAV (net asset value) of the fund. In terms of liquid funds, this doesn’t pose much of a threat as fluctuations may be minimal. Yet, you may want to reflect on some factors before you invest in liquid funds:
Liquid funds may not be completely free from the bane of risk, but they are relatively less risky than equity-oriented mutual funds. As liquid funds are invested in for short periods, they don’t tend to feel the impact of fluctuations in the markets. Nonetheless, consider the fact that the credit ratings of underlying securities may suddenly drop, and this may pose some risk. All in all, if you are an investor who is seeking minimal risk with relatively low to moderate returns, such funds may be good for you to park your money for a short period.
You may contemplate investment in liquid funds if you wish to invest some surplus cash in a short-term investment vehicle. You may also consider these funds as they give you liquidity when you want it, and offer better returns for short periods than other investment channels like bank fixed deposits, or even savings accounts.
In case you wish to invest in a fund with potentially assured returns and low expense ratios, you may think about liquid funds. These funds may suit short-term investors who would not like to take risks with equity.
It is important to assess your own financial goals and requirements before you invest. Liquid funds may be suited to you if you want short-term gains or wish to create an emergency fund.
Who Should Invest in Liquid Funds?
Investment horizon – As the funds invest in securities with short maturity periods, liquid funds are ideal for investors with an investment horizon of up to 3 months. However, investors with a longer investment horizon can opt for a longer duration, such as 6 months or a year.
Higher returns than a savings account – Individuals who keep their funds in the bank as deposits can benefit from liquid funds through greater flexibility and steady returns. The best-performing liquid funds offer flexible holding periods with easier exit options.
Contingency funds – Liquid funds are excellent options to set aside your contingency corpus or an emergency fund. This comes with the security of keeping the funds safe as the funds themselves are less risky and volatile. To add to this, you can also redeem them whenever required.
Temporary investments – The best-performing liquid funds are crafted in a way that helps you park funds while also helping you earn a stable and s