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What are liquid funds?

Sometimes, when you’re eyeing the markets for the perfect investment opportunity, you might have capital sitting in your bank account for a long time. This money, usually, only earns an interest in your savings account without amounting to much more.

In this article, we’re going to learn about liquid funds, which are instruments that allow you to park your excess funds for a short time and earn more than in your savings account.

What are liquid funds?

Liquid funds represent a category of mutual funds in India that primarily invest in short-term money market instruments such as treasury bills, certificates of deposit, commercial paper, and term deposits with a maturity of up to 91 days.

A quick look at the performance of liquid funds will tell you that these funds offer around 5-6% returns on average. Hence, they are better than the 4% returns earned on savings account deposits.

These funds not only preserve capital, but they also provide fairly stable returns in the short-term. The primary investment strategy involves investing in low-risk debt and money market instruments with short maturities, thereby minimising interest rate risk and credit risk.

Does that mean they’re risk-free? Absolutely not.

  • Although liquid funds primarily invest in high-quality instruments, there is still a risk of default by the issuer of these securities, which could impact the fund’s returns. This is called credit risk.
  • Fluctuations in interest rates can affect the NAV (Net Asset Value) of liquid funds, although this risk is relatively low compared to longer-duration debt funds. This is called interest rate risk.

Investing in liquid funds in India

Any individual, corporate entity, or institutional investor can invest in liquid funds. There are no specific eligibility criteria, making them accessible to a wide range of investors.

Here are some options:

  • Quant Liquid Fund (5.79% p.a.)
  • Mahindra Manulife Liquid Find (5.57% p.a.)
  • Aditya Birla Sun Life Liquid Fund (5.55% p.a)
  • Edelweiss Liquid Fund (5.55%)
  • Baroda BNP Paribas Liquid Fund (5.53% p.a.)

The process

There are two ways of investing in these funds in India:

  • The direct route: Invest directly with a mutual fund house on their website. This can offer lower expense ratios but requires more research and management of your investments.
  • Through a broker or middleman: Invest through a Registered Investment Advisor (RIA) or online platforms like Zerodha, Groww, etc. These platforms offer convenience and guidance but might charge additional fees.

Where does your money go?

Liquid funds, by definition, exist to provide liquidity to you and your investment strategy. Hence, when you park your money with these funds until a better investment comes along, you want your capital to be safe.

Liquid funds, therefore, invest in money market securities that are (largely) free from credit risk and market risk. Most of these are debt instruments issued by the government or very trustworthy corporate entities.

  • Certificate of deposit (CD): Similar to a fixed deposit, a CD is a savings account offered by banks that locks your money in for a predetermined period. Unlike a regular fixed deposit, however, CDs typically come with stricter withdrawal penalties before the maturity date.
  • Commercial paper: Imagine a large, highly-rated company borrowing money directly from investors by issuing short-term IOUs called commercial paper. These are unsecured investments, meaning the company’s promise to repay is the only guarantee. In exchange for this slightly higher risk, investors can potentially earn a higher return compared to traditional savings accounts.
  • Government-issued treasury bills: If the Indian government needs short-term funding, they might issue treasury bills. These are essentially risk-free loans to the government with a maturity of one year. As a reward for trusting the government with your money, you’ll earn a fixed interest rate, though it might be lower compared to other investment options due to the minimal risk involved.

Frequently Asked Questions

Are there any lock-in periods associated with liquid funds?

No, liquid funds do not have any lock-in periods. Investors can redeem their units at any time during market hours without incurring any exit load or penalty. The redemption proceeds are generally credited to the investor’s bank account within one business day.

How safe are liquid funds compared to other investment options like fixed deposits?

Liquid funds are considered relatively safe investments due to their focus on high-quality, short-term money market instruments. While they are not entirely risk-free and are subject to credit risk and interest rate risk to some extent, they typically offer higher liquidity and potentially higher returns compared to traditional fixed deposits.

What factors should I consider when choosing a liquid fund?

When selecting a liquid fund, investors should consider factors such as the fund’s track record, expense ratio, portfolio composition, fund manager’s expertise, and the fund house’s reputation. 

Can I set up systematic investment plans (SIPs) in liquid funds?

Yes, many mutual fund houses offer the option to set up systematic investment plans (SIPs) in liquid funds. SIPs allow investors to invest a fixed amount regularly at predefined intervals, thereby facilitating disciplined investing.

How are dividends from liquid funds taxed?

Dividends from liquid funds are now taxed as per the investor’s applicable income tax slab, following the abolition of Dividend Distribution Tax (DDT) in April 2020. This means that dividends received from liquid funds are added to the investor’s total income and taxed at their marginal tax rate.

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