What are Liquid Debt Funds & How Does Liquid Debt Fund Work?

13 Nov 2021|

1 min read |

by ICICI Securities Team

Your investments must align with your financial goals. If you are looking to create an emergency fund or a pool for making a down payment for a home or a car loan, liquid funds are for you.

Definition of liquid funds

Liquid funds are a category of debt-based mutual funds which are used for short-term investments.
Liquid funds invest capital in debt instruments that mature in 91 days.
Liquid funds are intended to provide stability and safety to investors.
Since liquid funds have a maturity of 91 days, they have low sensitivity to interest rate fluctuations. That makes them less vulnerable to market conditions.
The maturity of a liquid fund portfolio is tied to its underlying assets, which helps garner higher returns on any investment.
While they emulate the liquidity aspect of a savings bank account, liquid funds have no lock-in period, i.e., they have little to no penalty if they are closed before their maturity dates.

Additional Read: Four benefits of investing in debt mutual funds

Composition of liquid funds portfolio

Liquid debt mutual funds portfolios are typically composed of different debt instruments with high return rates. These may include the following:

Commercial papers, also called promissory notes, are issued by financial institutions and commercial entities. These are unsecured instruments that have high credit rates and are furnished at discounted rates. They are redeemed at face value—the difference between the price of the issue and the redemption price is the profit earned by investors.
Treasury bills are instruments issued by the government of India for tenors of either 91 days, 182 days or 364 days. They have no interest but are issued at a discount, with the difference between the issue price, and the actual value being the profit margin. Treasury bills have the lowest rate of return out of all market instruments but are also the safest due to their being backed by government guarantees.
Certificate of deposits is term deposits with lock-in periods similar to fixed deposits. Scheduled commercial banks issue these.

Additional Read:What are arbitrage mutual funds?

Factors to consider while investing in liquid funds

Liquid debt funds are generally low-risk investments, but they are still subject to the risk of degradation of the credit value of underlying assets, which investors must take into account while they make any investment.
Liquid funds fall under short-term capital gains, which are added to the overall income of an investor and taxed under the standard tax bracket the investor falls in.
Liquid funds typically involve some expenses during their investment. Funds with low expense ratios are generally the ones recommended by experts.
Liquid funds are suited to fulfil short-term requirements only. Investors looking for longer tenures must not invest in liquid funds.

Conclusion

Liquid funds represent an alternative to traditional savings bank accounts due to their higher return rates and little to no penalties for early termination of said funds. This makes liquid funds perfect for those with a high degree of idle currency, since those can be invested into what are essentially temporary havens.

Additional Read:What are tax saving mutual funds and how do they work?

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