LA liquid fund is a category of mutual fund schemes that invest in debt and money market securities with maturity of up to 91 days only. Investments by these funds are in debt instruments with residual maturity of less than 91 days at the time of investing, which include Treasury bills (T-bills) Commercial Paper (CPs), Certificate of Deposits (CDs), Bank Term Deposits among others.
Key Features of Liquid Funds
- A liquid fund is an efficient financial instrument to invest or park money for a short span of time that may be needed in a few weeks or months later. Like any other mutual fund investment, there is no guarantee of any return or principal in liquid funds. Yet the very structure of these funds makes them a suitable option to invest money even for short-term periods compared to keeping money in an interest earning fixed tenure financial instrument.
- You can take your money out of the fund at any point in time, even the very next day from your investment date, which means investors can earn accrual for every day of the investment.
- Unlike some instruments in which the tax deducted at source or the TDS is applicable at the time of redemption, there is no TDS on redemption of liquid funds.
- Most often, exit load or the fee charged for exiting the fund prematurely, isn’t applicable if investments are for a week or longer. This reduces the investment expenses that are normally associated with mutual fund investments.
How Do Liquid Funds Work?
The amount invested in a liquid fund before 2:00 pm of a trading day is processed as per the previous day’s net asset value (NAV), as long as the funds are credited to the asset management company’s (AMC) collection account before 2:00 pm and the application reaches the AMC’s branch before time. So, if a purchase transaction in a liquid fund is submitted on X day, the applicable NAV is of the day prior.
In case of redemption, the redemption is credited in the investor’s account on the next working day. For instance, redemptions received on Friday before 3.00 pm will be processed on Sunday’s NAV and the payout happens on Monday.
The main source of earnings for a liquid fund is through the interest income on their debt holdings and a very small part of their income may be generated via capital gains. What this means is that when interest rates fall, bond prices go up and when interest rates rise, bond prices fall.
- As a liquid fund primarily invests in short-term securities, its market value does change as much when interest rates fluctuate.
- This means that liquid funds may not incur significant capital gains or losses.
- In a rising interest rate environment, liquid funds often outperform other debt funds because while their interest earnings go up (as maturing shorter tenure securities get parked in higher interest bearing new ones), their market values suffer only to a limited extent due to their relatively lower capital losses (less sensitive to interest rate movements on account of lower maturity investments) vis-à-vis other debt funds.
Liquid Funds are not totally risk-free. For instance, as liquid funds predominantly invest in debt instruments, they are a subject to interest rate risk. So, any change in the prevailing interest rates may cause a rise or fall in the price of the debt instruments, thereby impacting returns of the fund, which vary on a daily basis. Debt instruments also carry credit risk. However, credit risk can be considerably mitigated through conservative investment policy like investing in sovereign securities and high grade credit instruments viz. AAA rated securities.
How Are Liquid Funds Taxed?
Like other mutual funds, investments in liquid funds are also subject to income tax. The tax implication depends on the holding period of your investments in the fund, and the type of your investment plan, which could be growth or dividend. In case an investor has opted for dividend, taxation will be dependent on prevailing government policy on dividend taxation for that particular class of investor.
In case of a growth plan, liquid funds are subject to possibly two different forms of taxation: short-term capital gains tax and long-term capital gains tax.
Short-Term Capital Gains:
If you invest in the growth plan of a liquid fund and if you redeem your investment before three years (36 months), then you have to pay short-term capital gains (STCG) tax, which will be taxed at the income tax slab rates. This means, the gains are added to your income and taxed at the income tax slab rate that you fall under.
Long-Term Capital Gains:
If you redeem your investments in a liquid fund after three years (36 months), then you are subject to long-term capital gain tax (LTCG), which includes indexation benefits, and is taxed at the rate of 20 per cent. The indexation benefit adjusts the gains for inflation, using the cost of inflation index (CII) as provided each year by the government, before calculating the capital gain. This generally reduces the tax incidence on your long term capital gains.
This nature of taxation makes liquid funds suitable for better post tax returns and additionally a flexible holding period vis-à-vis other fixed rate-fixed tenure debt-oriented investments.
What Makes Liquid Funds Suitable for Cash Management?
Optimal management of cash surpluses could add significantly to the overall returns for investors. Let us first understand this aspect in the case of a company, which needs to keep part of its money in non- interest earning bank accounts viz. current account. This is required since companies need to have easy access to cash for day-to-day working as well as any urgent need for cash that may arise for business requirements.
- Ideal cash management would include optimal division of the surpluses amongst bank accounts as well as avenues like short term deposits and liquid funds to ensure that company’s cash earns commensurate returns, while it may be lying idle, till final deployment for company’s business requirements.
- This short period could be a week or fortnight or month or during some holiday season when companies are shut.
- Instead of the money lying unused in a current account, moving part of the money from the current account to a liquid fund and back to the current account when required, can earn returns that would otherwise not be possible.
- Banks, pension funds, insurance companies, and high net-worth individuals, large organisations and institutions benefit from investing money in liquid funds.
Should You Invest in Liquid Funds?
The same approach can be adopted by us for efficient gains when we suddenly receive a large sum of money. This could be owing to circumstances such as receiving an annual bonus, or the sale of an asset which needs some detailed deliberation before suitable deployment or even the maturity of a bank deposit, among many other possibilities.
The very nature of liquid funds makes them an ideal vehicle to park money for a short while before you make up your mind on exactly where to deploy it for the medium to long term.
- Liquid mutual funds make for a good choice when one has a lump sum for long-term investing, which they wish to invest systematically or periodically through a systematic transfer plan (STP) into another asset class like equity.
- Likewise, one could create an income stream by investing their lump sum savings into a liquid fund from which a systematic withdrawal (SWP) feature can be structured to receive a monthly pension.
- Such tools can be conveniently used to address an individual’s financial needs.
“An investment in knowledge pays the best interest.”
Benjamin Franklin
How To Select A Liquid Fund?
Like selecting any other mutual fund, you need to check the following:
- Read the offer document and also check the track record of a liquid fund for consistently good performance and superior portfolio quality.
- Do look at the expense ratio of these funds, as one with a lower expense ratio, ceterisparibus, has a greater chance of having higher returns.
- Check the investment portfolio of the fund you invest in for credit quality and liquidity for both short and long-term. Always go for a fund that has a long-term track record and has not had any past instance of credit events or any other issues with respect to liquidity in the fund. The core reason to invest in a liquid fund is for efficient cash management for a short time and not wealth creation.
- Remember that one of the most important advantages of investing in liquid funds is the inherent high liquidity they offer.
Bottom Line
Liquid funds carry one of the lowest investment risks among all types of mutual funds. Factors that contribute to liquid funds emerging as popular choice for institutional as well retail investors include –
- Short-term nature of debt securities, in which these funds are invested make them less prone to adverse movements related to interest rate fluctuations in the markets
- The regulatory characteristics mandated for underlying investments by these funds make them highly liquid portfolio and hence well suited for short-tenure investments
- The open-ended nature of these funds make them better suited for a flexible tenure of investment horizon and a possibility of higher returns potential for the investors versus commensurate fixed tenure-fixed return debt investments.
The choice of growth, dividend and dividend re-investment options can be used to suit your specific investments requirements, making liquid funds suited to a variety of investment needs for short-term investing of cash surpluses
