Liquid funds are a great option if you are looking to invest in the short term. They can be your go-to option for investing if you want to fund short-term goals like a vacation, a wedding or renovation of your house or setting up an emergency fund to meet any unplanned expenses. They can be used to fund any future goal. Before you are comfortable investing in liquid funds, you may want to know what liquid funds are? What kind of returns can you make? What is the investment horizon? Is it truly risk-free? How liquid are they? Let us learn more about liquid funds.
What are liquid funds?
Mutual funds are debt-oriented or equity-oriented and could be open-ended or close-ended. At times, they are hybrid carrying a mix of debt and equity portions. Liquid mutual funds are a type of open-ended debt fund. Debt funds invest in debt instruments or fixed income securities such as government or corporate bonds and money market instruments. Liquid funds or liquid mutual funds are short-term debt funds that invest in money market instruments of very short tenure (residual maturities of up to three months).
Where do liquid funds invest?
The money market instruments that liquid funds invest in include commercial paper, government treasury bills, call money, certificate of deposits, term-deposits among others. These instruments most often have a maturity period less than 91 days.
Why are liquid funds popular?
Since liquid mutual funds do not invest in volatile markets like stocks or long term debt instruments, they are considered less risky. But, these liquid mutual funds manage to give decent returns. They are also liked for their liquidity. Although they do not provide returns as high as some of the large-cap equity schemes, liquid funds are still popular among retail investors for various reasons. Let us take a look at these factors:
Liquid funds are the flavour of the season with new investors looking to park cash in short-term but safe instruments like debt. Since these mutual funds invest in ultra short-term debt-like money markets with a maturity profile not more than three months, the risk due to interest rate changes is further reduced. These funds invest in government debt, which is known to be the safest. Even otherwise, these funds exclusively invest in top-rated corporate debt. The type of instruments they invest in impacts the credit rating of the liquid fund.
These liquid mutual funds are effortless and quick to access when it comes to redemption. At times, you may be in dire need of funds. In such a situation, on filing the redemption request, the money lands in your account within a working day.
You start earning profits on liquid funds right from the day you invest in them.
Liquid mutual funds give you total flexibility. You are not bound by a lock-in period. You can exit liquid funds as per your convenience, after even a single day or stay invested until maturity.
With liquid funds, the maturity of the portfolio is matched with the maturity of the underlying debt instruments. This boosts returns.
Different types of liquid fund plans
Within liquid funds, you can find growth mutual fund schemes and dividend mutual fund schemes. Growth mutual funds aim at capital appreciation. These growth mutual funds do not give out dividends generally. They reinvest the notional dividends to give you a larger NAV on maturity. Based on the frequency of dividend pay-out, the dividend mutual funds come as weekly, monthly, and daily dividend plans.
No exit or entry load
To make liquid funds more accessible for retail investors, these funds do not charge an exit load. An exit load is a charge for redeeming your investment before the due period.
How Do Liquid Funds Work?
To provide safety of investment and easy liquidity, liquid funds invest in very short-term and good quality debt. Fund managers ensure the fund holds no maturity longer than three months in most cases. This makes the fund operate tightly and with minimal capital risk. In case of liquid funds, you will not see drastic movement in the fund value daily.
Are liquid funds genuinely risk-free?
Although liquid funds are less risky than equity schemes, they do entail broader risks like sharp revisions in interest rates or likelihood of diminished credit quality.
- Interest Rate Risk
Debt funds invest in bonds and debentures. The prices of these bonds are associated with benchmark interest rates. When the interest rates rise, the bond prices fall, and when interest rates fall, the bond prices rise. But, the interest rate risk in case of liquid funds is negligible as liquid funds invest in very short maturity instruments. The bond’s yield on a price curve is steeper as the duration of the debt instrument increases.
- Credit Risk
While products like fixed deposits are insured, there is always a credit risk involved in case of liquid funds that invest in the money market. Liquid funds also invest in non-government debt like commercial papers, corporate bonds, certificate of deposits among other instruments. If an issuer of a bond or commercial paper, held by the fund manager, fails to honour the repayment, the instrument will be downgraded. When the creditworthiness of the issuer is reduced, it has a bearing on the bond price too. Downgrading of the issuer will lead to a fall in bond prices which will, in turn, affect the fund’s net asset value.
- Inflation Risk
Risk of inflation is more of a derivative risk. When the price of things in an economy rises, the apex bank will be forced to increase the interest rates to make credit expensive. When interest rates rise, bond prices will fall. Falling bond prices will bring down the net asset value of the fund.
How are the returns?
In calculating returns, one has to keep in mind that investors do not have an entry or exit load to pay, which eats into the net asset value of other mutual funds. Data shows, top-rated liquid funds have returned historically anywhere between 6.5% and 7.5% over a year.
Who should invest in liquid funds?
You may have received an increment bonus or unexpected gains. If you are looking to park surplus cash in a short-term instrument for a short-term goal like a vacation or a wedding in the family then, liquid funds are for you. More recently, investors have been using systematic transfer plans to reinvest proceeds from liquid funds to equity schemes. This is less risky than making lump sum investments and works like a systematic investment plan (SIP).
How are liquid funds taxed?
If you hold liquid funds for more than three years, you will have to pay long-term capital gains tax with indexation (price adjusted to inflation). If you hold it for less than three years, you pay tax according to your tax bracket. For dividend plans, you will also have to pay dividend distribution tax of 29.12% (for Individuals/HUFs/NRIs).
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Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.