What is a liquid fund and when to invest in it
In India, there exist multiple kinds of debt mutual funds categorized according to various durations, like overnight funds or long-duration funds. In this article, we will talk about one such type of a debt fund, known as liquid funds.
What is liquid fund?
Let’s start by describing what a liquid mutual fund, or a liquid fund is. A liquid fund is a debt fund that invests in debt and money market securities like commercial papers, certificates of deposits, treasury bills, etc. with the objective of yielding fixed returns. According to the norms laid out by SEBI, liquid funds are only permitted to invest in debt and money market securities with maturities up to 91 days.
The returns delivered by liquid funds hinge upon the current market yield of the securities held by the fund. Since the prices of short-term securities don’t tend to change as much as the prices of long-term bonds, the returns delivered by liquid funds tend to be stable as compared to other debt funds and considered safe with a minimal capital risk.
One of the primary advantages of liquid funds is the high level of liquidity. Liquidity can be defined as a measure of how quickly an asset can be converted to cash at a fair value.
How does a liquid fund work?
Let’s now get into the underlying details about the functioning of a liquid fund.
Firstly, let’s understand where liquid funds invest in. The securities which liquid funds hold are characterized by 3 features. They have short-term maturities, are of good credit quality and are highly liquid. As mandated by SEBI norms, liquid funds are not permitted to invest in risky assets.
Let’s now talk about the source of their earnings. The interest payments or difference between the current price and maturity value on the debt holdings of the liquid fund are their primary source of earnings. One salient feature about the short-term securities which liquid funds invest in is that their market value does not respond much to the interest rate changes in the market. What this means is that liquid funds tend to not give significant capital gains or losses. Generally speaking, liquid funds tend to outperform other debt funds in a rising interest rate environment mainly due to the resultant increase in the yield of underlying securities and their market value not suffering much. In short, liquid funds tend to have a very low interest rate risk.
Benefits of liquid funds
Let’s now look at the benefits associated with liquid funds.
Firstly, the primary focus of liquid funds is to provide capital protection, steady returns, and liquidity to their investors. The underlying assets of a liquid fund have a maturity period of up to 91 days due to which they generally don’t experience a lot of volatility. Resultantly, the value of the liquid fund tends to remain fairly stable throughout different interest rate cycles in the market.
On top of this, liquid funds are relatively low cost debt funds as they are not actively managed unlike some other debt funds. Due to this, they are able to maximize the effective return to their investors.
Another benefit is the flexible holding period with no lock-in period. Due to the short-term maturities of the underlying securities, these funds happen to be highly liquid letting investors redeem their capital as per their convenience. An investor can also stay invested in the fund as long as deemed necessary by them. There is no applicable exit load when one exits the scheme after 7 days of investment and a small exit load is charged for redeeming within 7 days. This makes liquid funds easier to enter and exit while earning more returns than savings accounts or fixed deposits. However, one should always remember that liquid funds are not risk-free. If the credit ratings or price of the underlying debt securities were to drop, then the Net Asset Value of the liquid fund can witness a drop as well.
When to invest in liquid funds?
Let’s now try to understand when liquid funds may be a good choice for investing.
Liquid funds may be a good investment choice for investors looking to park their money without taking much risk on their capital. These funds are suitable for a short period and even good for the medium term if you have a low-risk appetite.
Other than this, liquid funds can be a good choice for investors who need to park their funds temporarily until they decide where they will deploy this additional capital. Similarly, investors may use liquid funds to keep contingency funds as the main objective of liquid funds is to provide liquidity and safety while giving modest returns along with being redeemable whenever required by the investor.
Taxation of liquid funds
Let’s now go through the tax implications of investing in liquid funds.
Two kinds of tax, namely short-term capital gains and long-term capital gains are applicable for those investing in liquid funds. If an investor were to sell their liquid fund units before a holding period of up to 3 years, then the returns are termed as short-term capital gains and are taxed at the slab rate applicable to the investor. If the units of the liquid fund are sold after being held for more than 3 years, then the returns are termed as long-term capital gains and are taxed at a rate of 20% with indexation benefits.
How to select the right liquid fund?
Let’s now understand how an investor may go about selecting a liquid fund.
As we now know that liquid funds invest in short term securities with maturities up to 91 days, so it makes sense for investors to look at consistency to assess how a liquid fund stands up to similar funds of its kinds. One needs to ensure that the fund which they choose consistently beats the benchmark and its peer funds over multiple interest rate cycles.
One also needs to keep in mind the expense ratio of a liquid fund, which is the annual amount charged by the liquid fund for managing the investment portfolio and compare it across its peer group. Generally, higher the expense ratio, lower is the final net return to the investor. One also needs to look at the credit quality of the underlying debt securities of the liquid fund. A high credit rating means low credit risk, which means the likelihood of the default on principal and interest amount is low.
All in all, one should understand that liquid funds are characterised by their ability to keep investor’s capital relatively safe and stable. So, liquid funds happen to be a good avenue for capital preservation.
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