What are Liquid Mutual Funds? Benefits, Risks, Instruments and Taxation on Liquid Funds
Liquid funds are a flexible investment option and a type of debt fund. They invest in debt and money market instruments, typically maturing within 91 days. This short-term nature allows you to park surplus funds for a few weeks to a few months, helping you to make strategic investment choices. This article will discuss what liquid funds are and provide guidance on investing in them.
What are Liquid Mutual Funds?
Liquid mutual funds in India are debt funds that invest in short-term debt instruments like treasury bills, commercial papers, and certificates of deposit, often issued by businesses for up to 91 days. Due to their short loan tenure, liquid funds are relatively safe but not the safest. Overnight funds, which invest in instruments maturing in one day, are typically safer. Liquid funds have no lock-in period, and redemption requests made on business days are processed within 24 hours.
Liquid funds generally invest in high-quality, fixed-income liquid securities that mature quickly, making them a low-risk option for investors. Although the returns are market-linked and can occasionally be negative, this is rare since these funds typically invest in low-risk, short-term assets.
What are the Underlying Instruments of Liquid Funds?
Liquid funds invest in instruments that typically mature within 91 days. As a result, their returns can be lower than those of other debt instruments with a longer maturity period, such as short-term funds, ultra-short-term funds, and low-duration funds. However, under common circumstances, liquid funds give better returns than overnight funds. They also typically offer better returns than bank interest rates and, thus, can be a suitable alternative investment option for investors. However, this depends on the prevailing market interest rates. In low-interest rate environments, bank fixed deposits may outperform liquid funds.
How do Liquid Funds Work?
To understand liquid funds, knowing their investment strategies and how they generate returns is crucial.
- Investment Strategies of Liquid Funds: Liquid funds invest in short-term, high-quality, highly liquid securities. SEBI’s guidelines reinforce these features by allowing investment only in listed commercial papers and limiting sector exposure to 25%. They cannot invest in risky assets as defined by SEBI, which helps mitigate credit risk. Additionally, liquid funds must hold at least 20% of their assets in liquid products like cash and money market securities to meet redemption demands quickly.
- Earnings Sources: Liquid funds primarily earn through interest on debt holdings, with minimal income from capital gains. This is due to the inverse relationship between bond prices and interest rates, which is more pronounced for long-term bonds. Since liquid funds invest in short-term securities, their market value is less affected by interest rate changes, leading to low capital gains or losses. In a rising interest rate environment, liquid funds can outperform other debt funds because their interest earnings increase, short-term securities adjust quicker to rate hikes. and their market values experience limited capital losses, resulting in low-interest rate risk.
Who Can Invest in Liquid Funds?
- Liquid funds can offer higher returns than bank deposits for short-term investments, making them a better option for those seeking minimal risk.
- These funds invest in assets that expire within 91 days, so they are ideal for investors looking to stay invested for up to three months.
Features of Liquid Funds in India
Here are the key features of liquid funds in India:
- Returns: Liquid funds generally offer higher returns than traditional savings accounts or fixed deposits, typically ranging from 4%-6%. These returns can vary based on portfolio management and expense ratio.
- Easy to Invest: You can start investing in liquid funds with as little as Rs 1,000.
- High Liquidity: Investments can be redeemed within 24 hours, making them ideal for emergencies.
- Variety of Options: Several categories are available, allowing you to match your investment with your risk tolerance.
- Taxation: Liquid funds have a favourable tax structure, with long-term capital gains taxed at 20%.
- Low Risk: These funds invest in high-rated short-term instruments, resulting in lower risk.
- No Lock-in Period: Liquid funds offer immediate liquidity, making them a flexible option for meeting financial needs without a lock-in period. Liquid funds offer flexibility in terms of holding periods. They can be used for both short-term investments and longer-term emergency funds.
- Financial Goals: They are useful for building emergency funds, providing higher returns and easier liquidity than bank accounts.
- Costs: Liquid funds charge an expense ratio for managing the funds, capped at 1.05% by SEBI.
How to Invest in Liquid Funds?
You can easily invest in liquid funds by following these steps:
- To invest in mutual funds, you can visit an equity investment platform such as smallcase or Tickertape.
- The next step would be to research and identify the best liquid funds to invest in which aligns with your investment thesis. You can easily select and learn more about the best liquid funds with the help of a financial tool like the Tickertape Mutual Fund Screener. With 50+ pre-loaded filters, it helps you to create a comprehensive list by giving insights about the fund’s performance. Try it now!
- Once you have selected the funds based on different metrics and parameters, go to smallcase.com or the smallcase app, and login via your phone number. Click on ‘Discover‘ and enter the name of the specific mutual fund name in the search bar and hit enter. You can click on ‘invest now’ and select whether you want to invest a lump sum amount or start a SIP and start investing!
Advantages of Investing in the Best Liquid Funds
Here are the advantages of the best liquid funds in India that you might find helpful.
- Cost-Efficiency: Liquid income program funds can be less expensive than actively managed debt funds. Their lower expense ratio may result in a relatively higher take-home return.
- Lower Risk: They tend to have lower risk levels because the underlying securities typically mature within 91 days. This might reduce the potential for volatility in these funds.
- Flexibility: As open-ended mutual funds, they may offer the flexibility to redeem your units at your convenience. However, it’s important to note that a small exit load may be imposed if you redeem within seven days from the date of allotment.
- Efficient Processing: Redemption requests are typically processed within one working day. In some cases, certain they may offer the option of instant redemption.
Risks of Investing in Liquid Mutual Funds in India
Short-term liquid funds are a type of mutual debt fund with a maturity of up to 91 days. This can make them a relatively low-risk investment option, but there are still some risks to be aware of before investing. Here are a few potential disadvantages of liquid funds:
- Credit Risk: Although they typically invest in high-quality securities, there is still some risk of default, especially if the issuer’s financial condition worsens.
- Interest Rate Risk: They invest in short-term securities, so the impact of interest rate movements can be relatively low. However, liquid funds rarely suffer substantial losses due to rate hikes because of their short maturity.
- Inflation Risk: Inflation risk is the risk that your investment’s purchasing power may decline over time due to inflation. This is because investments may offer lower returns than other types of investments; there is a possibility that your investment may not keep pace with inflation.
Taxation on Liquid Funds in India
Liquid funds are taxed as debt funds in India. Understanding the latest tax regulations on debt mutual funds is crucial for effectively managing your investments. The Union Budget 2024 has introduced significant changes to the taxation of debt mutual funds. Here is a detailed breakdown of the new tax rules:
Short-Term Capital Gains (STCG)
If you sell your debt fund units within three years (36 months), the gains from these investments are considered short-term capital gains. According to the new budget, these gains will be taxed according to your income tax slab rate.
Long-Term Capital Gains (LTCG)
For debt funds held for over three years (36 months), the gains are categorized as long-term capital gains. The key points to note under the new budget are:
- Tax Rate: The tax rate for long-term capital gains on debt funds is now a flat 12.5%, regardless of the amount of gain.
- No Indexation Benefit: The benefit of indexation, which previously allowed investors to adjust the purchase price of their assets for inflation, has been removed for debt funds. This means that the entire gain from selling a debt fund after three years will be taxable at the flat rate of 12.5%.
Summary
| Capital Gains Tax | Description |
| Short-Term Capital Gains (STCG) | If you sell your debt fund units within three years (36 months), the tax will be as per your income tax slab. |
| Long-Term Capital Gains (LTCG) | For debt funds held for over three years (36 months), the tax rate is now a flat 12.5% without indexation benefits. |
What are the Factors You Should Consider Before Investing?
Before investing or figuring out which liquid fund is best, it is essential to consider the following factors:
- Risk and Returns: Evaluate the fund’s risk and return profile and ensure it aligns with your liquid investment options and risk tolerance. These funds may offer relatively low-risk investment options with modest returns.
- Expense Ratio and Other Costs: Check the expense ratio and other costs associated with the liquid schemes, as they can impact your overall returns. Lower expense ratio funds may result in higher returns for investors.
- Minimum Investment and Exit Load: Check the debt liquid fund’s minimum liquidity investment amount and exit load before investing. Some funds may have a higher minimum investment amount, while others may impose an exit load if you redeem your investment before a specified period.
- Credit Quality of Underlying Securities: Check the credit quality of the underlying liquid securities in the fund’s portfolio. These typically invest in high-quality debt instruments with low credit risk, but checking their credit ratings is essential.
- Liquidity of the Fund: Check the liquidity of the liquid MF, as it is essential to ensure that the fund can meet your redemption requirements. Highly liquid fund units can easily buy or sell, which refers to liquidity.
To Wrap It Up…
In conclusion, liquid mutual funds in India can be a good investment option for investors who seek high liquidity and moderate returns with low risk. These funds invest in highly liquid debt instruments with a short maturity period, making them attractive options for individuals, corporations, and institutions with surplus cash balances. They may offer higher returns than traditional savings accounts and fixed deposits while maintaining a low-risk profile. However, it’s advisable to carefully consider the associated costs, taxation rules, credit quality of underlying securities, and liquidity of the fund before investing.
Frequently Asked Questions About Liquid Funds
Liquid money is an asset that can be easily converted to cash without losing value. It is the most accessible form of wealth.
Liquid money is cash or assets that can be easily converted to cash without losing value. It is the most accessible form of wealth.
No, liquid funds in India do not have a lock-in period. You can redeem your investment at any time without penalty.
Liquid beEs are exchange-traded funds (ETFs) that comprise bonds issued by Indian public sector companies. They can give investors low-cost exposure to a diversified portfolio of these bonds, enabling liquidity and income from periodic interest payments.
Yes, investors can opt for SIPs in liquid funds. SIPs allow investors to build wealth over time and reduce the risk of market volatility.
Certificates of deposit(CDs), treasury bills, and commercial paper are examples of liquid funds. These funds typically include instruments that have maturity periods of upto 91 days.
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