Liquid Funds

Ever found yourself needing cash urgently? Indeed, these unforeseen twists and turns of life have a habit of throwing us into a tizzy, with us running around in circles trying to arrange the needed funds. Imagine having a financial safety net—a reliable pot of money lying at your disposal, prepared to bail you out whenever you need it the most. Liquid funds can help you in such cases. They offer financial security and peace of mind with the freedom to seize life's opportunities that come your way without hesitation.

In this article, we will be answering the question of what liquid funds are, how they actually work, and why they are an excellent addition to your portfolio of investments.

What is Liquid Fund?

Liquid Funds, as the name would suggest, invest in highly liquid money market instruments and short-term debt securities with a residual maturity of up to 91 days. The primary goal is to ensure that returns are maximised with high safety while ensuring optimal liquidity. The redemption request of these funds is generally carried out in one working day or T+1.

Top liquid mutual funds invest in the following high-quality, short-term instruments:

• T-Bills - These are short-term securities provided by the government, whose maturities extend to a maximum of one year. Since the government backs them, they are quite low-risk and highly liquid.‌‌
• Commercial Paper (CPs) - This is a short-term debt instrument that an entity issues without due collateral security to meet any sudden funding requirement. Basically, commercial papers are issued by those companies with strong credit ratings.‌‌
• Certificates of Deposit (CDs) - The time deposits offered by banks with fixed maturity dates are CDs.  These offer a pre-determined return and are low-risk, hence offering stability to liquid funds.‌‌
• Collateralised Borrowing and Lending Obligations (CBLOs) - These obligations are short-term instruments collateralised by borrowing and lending transactions. This increases liquidity management and is duly covered by high-quality assets.

Many retail customers regard savings bank accounts as the safest option for placing excess cash, thus allowing them easy access to funds at all times. However, consider alternatives like liquid funds and money market mutual funds if you want better returns.

You can dispose of surplus cash in money market mutual funds for higher post-tax returns with a reasonable amount of safety on principal and liquidity. Those searching for opportunities in equities or long-term fixed-income instruments temporarily park their money in liquid funds.

Equity investors use liquid funds to stagger their investments into equity mutual funds through a Systematic Transfer Plan (STP), as they feel this could be a better way of earning higher returns. Liquid Funds usually do not charge any exit loads and, thus, are fairly liquid, offering easy access to your money when needed.

How Do Liquid Funds Work?

The main objective of the liquid fund manager is to invest in liquid instruments of the highest credit quality, hence reducing the risk of default to a minimum. Capital protection remains their priority, while returns come second.

SEBI Guidelines

The Securities and Exchange Board of India (SEBI) regulates the operations of liquid funds to ensure that these funds remain safe and liquid. Intrinsic to the regulatory framework are:

• Sector Exposure Limits - SEBI limits the sector exposure of a liquid fund to a single sector to prevent concentration risk. This allows the fund to diversify its investments and cushions the impact of sector-specific meltdowns.‌‌
• Investment in Listed Commercial Papers -  Liquid funds are required to invest only in listed commercial papers, which provide better transparency and liquidity. The regulation ensures the fund holds high-quality securities.

How are Returns Generated?

Returns from liquid funds are generated through the interest accrued on the fund's underlying securities. These securities offer regular income, reflected as the fund’s returns. Liquid funds offer lower returns than other mutual funds because:

• Short-Term Investment - The investment is in short-term securities, typically offering lower yields compared to long-term investments.
• Focus on Safety - The focus on high credit quality and liquidity leads to more conservative investments. So, when risks are lower, the returns will also be lower.

Liquid funds ensure stability and easy access to funds, making them apt for investors whose aim is safety and liquidity at the expense of higher returns.

Benefits of Liquid Funds

Liquid funds come with many added advantages and, therefore, are ideal for investors looking for a perfect blend of liquidity, safety, and return. The main advantages accrued from investing in liquid funds are:

• Liquidity - It promises high liquidity. You can quickly convert all or part of your investments to cash without much loss. There is no lock-in period, so the funds are available immediately. The standard processing of a request for redemption takes 24 hours. ‌‌
• Low Risk -  Liquid funds reduce interest rate risk by investing in high-quality debt instruments with short tenor periods, generally up to 91 days. Therefore, it is suitable for any kind of conservative investor seeking stability in investment. ‌‌
• Endless Return Opportunities - Liquid funds give periodic returns in inflationary times. They are proving to be a good investment source for those investors who aim to look for an average but steady rise in investment. ‌‌
• Low exit loads and expense ratio - Being professionally managed, liquid funds have low expense ratios, allowing you to maximise profitability. Low exit loads, usually in cases of redemption in seven days, help access funds without additional charges. ‌‌
• Tax benefits -  Liquid funds have tax benefits if held for three years. At the time of redemption, you can benefit from indexation and treat the profit as long-term capital gain.

Risks Associated with Liquid Funds

Liquid funds are designed to be high-liquid, stable returns investment vehicles, yet they come with some risks, including the following:

• Credit risk - Liquid funds invest in high-grade, short-term securities. Still, some credit risk exists with liquid funds. Their underlying securities are generally high-quality credits and, therefore, carry less chance of default. However, any economic downturn or company-specific news might affect the credit quality of those securities.‌‌
• Interest Rate Sensitivity  - Liquid funds invest in short-term securities with a relatively lower sensitivity to rate changes and, therefore, help maintain returns at steady levels. However, interest rate fluctuations will affect returns, albeit less profoundly than in long-duration funds.‌‌
• Liquidity Constraints - Even though liquid funds are designed for high liquidity, sometimes, they may be limited. In case of market disruptions or financial crises, the ability to sell securities quickly at fair value may be affected. Large-scale redemption could pressure the fund's liquidity management. Specific problems of the underlying securities could also impact liquidity, though these cases are rare.

Who Should Invest in Liquid Funds?

Liquid funds are an exciting option for investors looking for relatively stable investments with more assured returns. Here's who would consider them worth the investment:

• Short-term Investors - Those individual or institutional investors looking for low-risk, short-duration investments may find liquid funds beneficial. They provide modest returns, usually within 91 days, and are appropriate for investors interested in stability. ‌‌
• Cash Reserve Holders -  For investors with surplus cash that is not immediately required, liquid funds are better as they give a higher return vis-à-vis traditional modes of investment. Such funds provide a safe place for excess cash holding with the benefit of earning slightly higher returns. ‌‌
• Investors Transitioning to Equity Funds - Liquid funds are meant for investors migrating from conservative investments to growth-oriented investments such as equity funds. Given the liquidity and stability of liquid funds, they are used to park funds for investors who want to gradually increase their risk exposure by migrating their funds to more aggressive investment options. ‌‌
• Emergency Fund Builders - Most investors build their emergency funds with liquid funds because they are low-risk, very liquid, and offer good returns. They also offer speedy access to the funds for necessities.

Factors to Consider Before Investing in Liquid Mutual Funds

A good liquid fund should have investments with low expense ratios, high credit quality, and a disciplined approach toward investment. All of these factors form the basis for the fund's general performance.

You can choose between growth and dividend options, where dividends may be daily, weekly, or monthly, depending on the amount of investment and the duration for which it is made. Before choosing to invest your money in liquid mutual funds, consider the following factors:‌‌

• Investment Horizon - Liquid Funds are best suited for short-term financial goals or temporarily parking surplus funds. For a long-term goal, other Mutual Funds would be more suitable. ‌‌
• Risk Tolerance - The low risk that comes with liquid funds doesn't mean they are entirely risk-free. Any mutual fund is subject to market risks. Ensure that this aligns with your comfort level of risk tolerance. ‌‌
• Financial Goals - Clearly outline your financial goal and ensure that your liquid fund investment satisfies your current and future financial needs. In case of a long-term goal, look at other investment options. ‌‌
• Liquidity Requirement - Consider your liquidity requirement. Liquid Funds are liquid, though the time taken for processing can defer the actual withdrawal time. ‌‌
• Investment Security - Liquid Funds are low-risk products, but you must check out the credit quality of the debt securities in a fund's portfolio.‌‌
• Return Potential: Liquid Mutual Funds offer reasonable returns that are usually less than equity mutual funds. Ensure that liquid funds' performance is in sync with your financial objectives.

Are Liquid Funds Better than FDs?

After the amendments to the Finance Bill 2023, debt mutual funds would fall under individual income tax slab rates. Even fixed deposits attract taxation according to individual income tax slabs. But in the case of fixed deposits, TDS is cut every time there is a maturity and renewal of a fixed deposit. There is no TDS in debt mutual funds; the taxes are always paid at the time of redemption of units.

Earlier, debt mutual funds were a better option than fixed deposits due to the indexation benefits and a lower tax rate of 20%, which comes into play if the investments are held for more than three years. This benefit has been taken away from April last year, and now returns will be taxed at applicable slab rates depending upon the income levels of the individual, irrespective of holding periods.

However, debt mutual funds are not without their relative merits over fixed deposits. They carry no pre-payment penalty, and investors can access their money without any delay, which is very useful for contingency funds or regular investments into equities.

In the last year, liquid funds, benchmarked against the CRISIL Liquid Debt Index and the Crisil 1 Yr T-Bill Index, delivered returns of 7.30% and 7.12%, respectively. Remember, returns from liquid funds are market-related, unlike fixed deposits. Some liquid funds that successfully beat fixed deposit returns are:

Top Liquid Funds to Invest in 2024

Here are some of the top liquid funds you can consider investing in:

Conclusion

Liquid funds ensure a secure, flexible, and effective way of managing your short-term financial needs. They can provide liquidity, stability, and reasonable returns. These benefits make liquid funds attractive to conservative investors and those who wish to open their investment avenues gradually to more aggressive investments. If you understand your time horizon, risk tolerance, and financial goals, you can better determine if liquid funds fit your strategy.‌‌Ready to take control of your finances? Consider investing in liquid funds today and consult with Choice experts.