Liquid Funds

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What are Liquid Mutual Funds?

Liquid funds are debt funds that lend to companies for a period of up to 91 days. These are the safest funds amongst all the mutual fund categories, owing to their extremely low lending duration.

Advantages of Liquid Funds

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• Suitable for putting money aside for emergencies

• Near zero risk of loss if someone invests for at least one month

• Have given up to 50% to even at times 100% higher returns than the savings bank account.

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How do Liquid Mutual Funds Work?

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Investment Strategy:

1. Short-Term, High-Quality, and Highly Liquid Securities:

   • Liquid funds typically invest in securities with short maturities, ensuring high liquidity and reduced interest rate risk.

2. SEBI Guidelines:

   • Recent SEBI guidelines reinforce the focus on good credit quality and liquidity. Liquid funds are restricted to investing in listed commercial paper, with an overall exposure limit of 25% in a sector.

3. Avoidance of Risky Assets:

   • Liquid funds are not permitted to invest in assets deemed risky by SEBI norms. This restriction aims to mitigate credit risk, reducing the likelihood of default by the companies whose papers the fund holds.

4. Minimum Liquid Assets:

   • SEBI mandates that liquid funds must hold at least 20% of their assets in liquid products, such as cash and cash equivalents. This requirement ensures that funds can quickly meet redemption demands.

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Sources of Earnings:

• Interest Payments:

  • The primary source of earnings for liquid funds is interest payments on their debt holdings. Given the short-term nature of their investments, interest income forms a significant part of their returns.

• Limited Capital Gains:

  • Unlike some other debt funds, liquid funds generate only a small portion of income through capital gains. This is due to the short-term nature of their securities, which results in less sensitivity to changes in market interest rates.

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Interest Rate Risk:

• Low Interest Rate Risk:

  • Liquid funds are designed to have very low-interest rate risk. Since they invest in short-term securities, their market values are less affected by changes in market interest rates compared to funds holding longer-term bonds.

• Performance in Rising Interest Rate Environment:

  • In a rising interest rate environment, liquid funds often outperform other debt funds. This is attributed to the fact that their interest earnings increase while the impact on their market values is limited due to relatively lower capital losses.

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Who Should Invest in Liquid Mutual Funds?

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Investors with a short investment horizon:

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• Liquid funds are best suited for those with an investment horizon of up to 3 months, as the funds invest in securities with comparable maturities. Investors with longer investment horizons? say 6 months to a year? should invest in slightly longer duration funds (say ultra-short duration funds) so that they can earn higher returns.

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Investors who invest in bank deposits:

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• Investors who keep their surplus funds in bank deposits can benefit from liquid funds on two fronts: greater withdrawal flexibility and better returns. In a traditional bank fixed deposit, funds are locked in for a fixed period; and an interest penalty is imposed on premature withdrawal. In contrast, liquid funds offer flexible holding periods with easy exit options. Money in bank savings accounts can be withdrawn at any time, but they offer around 3%?4% interest only, which is lower than the 5% plus usually earned by a liquid fund.

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Investors who want to keep Contingency Funds:

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• The purpose of liquid funds is to provide liquidity and safety while generating better than fixed deposit returns. Hence investors can park an emergency or contingency corpus in a liquid fund with the assurance that it will be safe and can be redeemed when necessary.

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Investors who need to Park Funds Temporarily:

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• Liquid funds are cash management products that are designed to keep funds safe while earning a small return. Hence, a large sum of money, say, from a bonus or sale of property or inheritance, can be temporarily parked in a liquid fund until the investor decides how to invest the corpus.

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Medium to Route Investments in Equity Funds:

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• Investors can hold funds in a liquid fund and use an STP to route investments systematically into an equity fund. This enables them to invest in equity periodically, while at the same time, the corpus in the liquid fund earns stable returns.

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Taxation on Liquid Mutual Funds

Investors earn dividend income and capital gains from overnight funds. Dividend income is not taxed in the hands of investors. Capital gain is the difference between the purchase price and the selling price of the units. The rate of tax on capital gains depends on the time for which the investor holds the units of the overnight fund.

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Short-term Capital Gains Tax:

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• If an investor stays invested for up to 3 years, capital gains are considered short-term capital gains and taxed at the income tax slab rate applicable to the investor.

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Long-term Capital Gains Tax:

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• If an investor sells the units of an overnight fund after holding it for longer than 3 years, it is considered as long-term capital gain, and the investor gets the benefit of indexation. This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. In other words, the taxable amount is reduced due to indexation. Long-term capital gains are currently taxed at a lower rate of 20%.

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In summary, liquid funds aim to provide investors with a combination of safety, liquidity, and reasonable returns. Their investment strategy focuses on short-term, high-quality securities, and they are structured to minimize interest rate risk, making them suitable for investors looking for stability and quick access to their funds.