Liquid funds

For the past couple of chapters, it was all a bundle of theoretical knowledge, isn’t it? Let’s take a break from that and look into a practical scenario. Meet Meera. She’s a 30-year old salaried professional, and she has just signed the deal and purchased her first house in the heart of Mumbai. 

Now, Meera has the following short-term goals.

• Purchase new furnishings for her house
• Repaint the interiors
• Make minor alterations to the house

These are goals that have very short time horizons, as you can no doubt figure out. Meera wants to make use of investments to mobilize the funds for these goals, but she’s unsure of how to proceed.

FDs are not very short-term, by nature.

Also, she needs an option that can give her a significant rate of return.

So, to sort out her dilemma, she approaches a financial advisor. Among the many options that the advisor short-lists, we have liquid funds. You may have come across this category of funds in the previous chapter.

But now, it’s time to scratch the surface and get to know what these liquid funds are all about.

What are liquid funds?

Within the debt fund market, liquid funds are among the most popular options. But what are they? As you saw in the previous chapter, liquid funds are open-ended debt funds that invest mainly in debt instruments that mature within 91 days. Since their maturity period is so short, they’re highly liquid. That should tell you why they’re called liquid funds. 

What do liquid funds invest your money in? Logically, it follows that these debt funds would choose debt instruments that mature within 91 days, isn’t it? Let’s check out which debt instruments qualify for this criterion.

• Commercial Paper (CP)

A Commercial Paper (CP) is a debt instrument that is issued by companies. They are issued at a discount and redeemed at par. Typically, they have a high credit rating.

• Certificate of Deposit (CD)

A CD is a time deposit, just like an FD. The main difference is that while you can break your FD to withdraw funds if needed, you cannot terminate your CD investment till maturity.

• Treasury Bill (T-bill)

You know this one, right? T-bills are government securities backed by the sovereign guarantee. T-bills are also issued at a discount and redeemed at part. Liquid funds generally invest in T-bills that have a maturity period of 91 days.

How do liquid funds work?

Liquid funds have two main objectives: 

• Capital preservation
• Liquidity

So, when you invest in liquid funds, you essentially invest in the short-term debt instruments that the fund manager has chosen as a part of the fund’s portfolio. At the end of the investment tenure, your units are redeemed and your capital is returned to you, along with the interest or returns earned. 

The average tenure for the maturity of the overall portfolio is generally kept at 91 days. By making the investment tenure so short, liquid funds are essentially less affected by movements in interest rates, particularly when compared with long-term funds. Also, since this is a highly short-term investment, there’s not much volatility involved. That’s why it may be a good idea to park any extra funds you may have lying around in liquid funds. 

Tax implications of liquid funds

When you invest in liquid funds, you can earn in the following two ways:

• Dividends
• Capital gains

The dividends are tax-free, but the capital gains (being short-term capital gains) are taxed in your hands as per your income tax slab rate.

For example, say you invest in a liquid fund and earn the following returns:

• Dividend: Rs. 6,120
• Capital gains: Rs. 10,327
• Your income tax slab rate: 30%

Now, your dividend will be tax-free, but the capital gains of Rs. 10,327 will be taxed as per your slab rate, i.e. at 30%.

Do liquid funds come with any risk attached?

Sure they do. Like all debt funds, or even mutual funds for that matter, liquid funds also have some degree of risk attached to them. A significant influencing factor here is the kind of investments that these funds make. Broadly speaking, these are the key risks involved in liquid fund investments.

• Interest rate risk

As the interest rates in the country keep changing, the bond’s price in the secondary market also fluctuates. The rule of thumb is that the bond price is inversely proportional to interest rates.

For instance, say the interest rate on a debt instrument was 7% when you purchased it. A while later, interest rates in the country drop to 6.3%. Now, since the instrument you hold pays higher interest, at 7%, its price goes up and its worth increases. Conversely, say the interest rates rise to 8.2%. Then, since your investment only pays 7% interest, its price drops.

So, when interest rates go down, bond prices go up.

And when interest rates go up, bond prices go down.

The longer you hold an asset, the more it’s prone to be exposed to interest rate fluctuations. This increases the interest rate risk. But, since liquid funds are only held for 91 days, the interest rate risk is negligible.

• Inflation risk

Inflation causes prices to rise over time, thus decreasing the value of money. Inflation risk refers to the risk that the returns offered by your investment may not be sufficient to beat inflation in the long run.

Typically, volatile, high-risk investments like stocks and equity funds also come with the possibility of earning higher, often inflation-beating returns. However, low-risk, long-term investments do not have this potential.

In the context of debt instruments, the longer the term to maturity is, the higher its inflation risk becomes. Why, you ask? Well, say you have a 20-year bond in your portfolio. If inflation rises more than you anticipated at the end of those 20 years, then, the interest and maturity payout will be worth less than expected. This is highly possible because estimating inflation over the long term is prone to errors.

Over the short term, however, it becomes easier to account for inflation. Liquid funds, with their short maturity periods, bear negligible inflation risk. 

• Credit risk

Credit risk, in the context of liquid funds, is the risk that the issuers of the debt instruments will default on their repayment of principal or the payment of interest. Unlike inflation risk and interest rate risk, this category of risk is not constant across liquid funds.

It depends on the quality of the debt instruments that a liquid fund invests in. Those that invest in debt instruments with high credit ratings bear lower credit risk. But those liquid funds that invest in debt instruments with low or average credit ratings come with a higher risk of the issuer defaulting. 

Why should you invest in liquid funds?

Now, say you are looking for debt investment options with a very low tenure to maturity. You could always directly park your funds in T-Bills or CDs, right? What’s the necessity to take the mutual fund route? Why choose to invest in liquid funds instead, when you can directly invest in the same debt instruments making up the liquid fund’s portfolio.

Well, there are two excellent reasons to choose liquid funds instead.

• You get the advantage of professional management

Understanding and managing debt funds is an art. It requires you to look at the microeconomic as well as macroeconomic forces driving the market, and often, individual retail investors have neither the time nor the resources required for this. 

This is why liquid funds, which are managed by professional fund managers, make a better alternative if you wish to invest in the debt market without compromising on liquidity.

• You enjoy access to unavailable debt securities

Investing directly in G-Secs is not often easy for retail investors. Tracking auction dates, high ticket sizes and the possibility of your bid not translating into an allocation may all stand in the way of your debt investment aspiration.

Liquid funds can help you circumvent these roadblocks and give your investment portfolio some much-needed stability and liquidity. 

Should you choose liquid funds?

In the example at the beginning of this chapter, recall how Meera’s advisor recommended she invest in liquid funds? That points to the fact that there are some investors for whom liquid funds are more ideal than they are for others.

So, how do you know if liquid funds are right for you? Here’s a quick preview of when you may benefit from choosing liquid funds for your portfolio.

1. If you are highly risk-averse and have a very low risk appetite
2. If you have some extremely short-term investment goals and financial goals
3. If you want to create an emergency fund that is easily accessible
4. If you want to diversify your portfolio and add in more debt or increase its liquidity 
5. If you know you’ll need some extra funds in the immediate future

If liquidity is your sole priority, you may as well choose to keep your money in a savings bank account, isn’t it? Well, that is true. But liquid funds have the upper hand in one area - they offer slightly higher returns than your average savings account.

Wrapping up

That sums up all the important things about liquid funds. If you believe that these may make for a good addition to your portfolio, ensure that the funds you choose come with tolerable risk, and check if they offer a higher return than your savings account.

And if 91 days is too short a tenure for you, but you still need short-term debt fund options, proceed to the next chapter to find out what your options are. 

A quick recap

• Liquid funds are open-ended debt funds that invest mainly in debt instruments that mature within 91 days.
• These funds invest in debt instruments like commercial papers, certificates of deposit and T-bills.
• Liquid funds have two main objectives: liquidity and capital preservation.
• The dividends earned are not subject to income tax, but the STCG is taxed at your income tax slab rate.
• Liquid funds are not risk-free. They come with interest rate risk, inflation risk and credit risk.