Liquid Funds

Liquid Funds: Basics, Things to consider and More

Liquid funds are debt funds that invest in short-term fixed-interest generating money market instruments. These can be treasury bills, commercial paper, and so on, which mature within 91 days.

1. How Do Liquid Funds Work?

Liquid funds aim at providing a high degree of liquidity and safety of the capital to investors. For this reason, the fund manager invests in high-credit quality debt instruments. The allocated proportions are as per the fund’s investment objective. The fund manager will ensure that the average maturity of the portfolio is three months.

This reduces the sensitivity of fund returns to interest rate changes. The fund value does not experience a lot of fluctuations. In addition to this, the maturity of the underlying securities is matched with the maturity of the portfolio. It helps to deliver higher returns.

Liquid funds are an excellent option to park your idle money. These are low-risk havens which offer higher returns than a savings bank account. Liquid funds try to emulate the liquidity aspect of a savings bank account. These funds don’t have exit loads. It gives you the freedom to withdraw funds as per your convenience.

2. Types of Money Market Instruments

As a liquid investor, you should know the following money market instruments:

a. Certificate of Deposit (CD)

These are time deposits such as fixed deposits offered by scheduled commercial banks. The only difference between FD and CD is that you cannot withdraw CD before the expiry of the term.

b. Commercial Paper (CP)

Commercial papers are issued by companies and other financial institutions that have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments issued at the discounted rate and redeemed at face value. The difference is the return earned by the investor.

c. Treasury Bills (T-bills)

T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. These are the safest instruments as the guarantee of the government backs these. The rate of return, also known as the risk-free rate, is low on T-bills as compared to all other instruments.

3. Who Should Invest in Liquid Funds?

Liquid funds are meant for those having substantial idle cash and are looking for short-term investment havens. Instead of parking your surplus funds in a savings bank account, you can invest them in a liquid fund. Excess funds include performance-based incentives, bonus, and other relevant gains made by selling capital assets.

Liquid funds can be used as a medium to invest in equity funds. You may initially invest the money in a liquid fund and then do a systematic transfer to an equity fund of your choice over a specified period. In this way, you would save yourself from placing large bets all of a sudden into equity funds.

4. Things to Consider as an Investor

a. Risk

The risk in mutual funds relates to fluctuations in net asset value (NAV). For liquid funds, the NAV doesn’t fluctuate too frequently as the underlying assets mature within 60 days to 91 days, and this prevents the fund NAV from getting impacted significantly by the fluctuations in the underlying asset price. However, the fund value might drop suddenly on account of a sudden downgrade of the credit rating of the underlying security. In simple words, liquid funds are not entirely risk-free.

b. Returns

Historically, liquid funds have been found to generate profits in the range of 7% to 9%. It is way higher than the mere 4% returns obtained on a savings bank account. Even though the returns on liquid funds are not guaranteed, more often than not, they have delivered positive returns upon redemption.

c. Cost

Liquid funds charge a fee to manage your investment called expense ratio. SEBI has mandated the upper limit of expense ratio to be 1.05%. Considering the hold till maturity strategy of the fund manager, liquid funds maintain a low expense ratio to offer comparatively higher returns over a short term.

d. Investment Horizon

Liquid funds are exclusively meant to invest surplus cash over a short period say, up to three months. Such short-horizon helps to realise the full potential of the underlying securities. In case you have a longer investment horizon of up to one year, then you may consider investing in ultra-short-term funds to get relatively higher returns.

e. Financial Goals

If you want to create an emergency fund, then liquid funds can prove to be very useful. In addition to receiving higher returns, these will also help you to take out your money quickly in case of emergencies.

f. Tax on Gains

When you invest in debt funds, you earn taxable capital gains. The rate of taxation depends on how long you stay invested in a debt fund. The duration over which you stay invested is known as the holding period. Gains made in the first three years is known as short-term capital gains (STCG). Capital gains made over three years or more is known as long-term capital gains (LTCG).

STCG from debt funds are added to the investor’s income and taxed according to his/her income slab. LTCG from debt funds is taxable at a flat rate of 20% after indexation.

5. How to Invest in Liquid Funds?

Investing in liquid funds is made paperless and hassle-free at ClearTax. Using the following steps, you can start your investment journey:

Step1: Sign in at cleartax.in.

Step2: Enter your details, such as the amount and period of investment.

Step3: Complete your e-KYC; it takes no more than than 5 minutes.

Step4: Invest in the most suitable fund from amongst our hand-picked mutual funds.


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