Liquid Funds

What are Liquid Funds?

Finding investment opportunities that offer liquidity must be a priority. Liquidity is the quality of purchasing assets or paying debts quickly without significant losses. You don't have to wait long to recover your principal when selling an investment. Liquid funds are mutual funds that invest in fixed income and money-market instruments with a credit rating of AA or higher.

Liquid funds returns are meant to be "cash-like" or "near-cash" in nature. This is different from a savings account that meets liquidity needs close to the term deposits/current accounts. Liquid funds are short-term goals with high liquidity requirements due to low time preference (medium-term investment horizon).

Who Should Invest in Liquid Funds?

Liquid funds are apt for investors who do not want to take any risk with their savings and park it in a safer option to get better returns than traditional bank accounts like savings and fixed deposits.

  • The conservative investor can invest in liquid funds as a parking option for their investment due for redemption within the next 3 to 6 months or even less than that.
  • For people who have excess cash or have lump-sum amounts that they would like to invest in for a short period, liquid funds are ideal.
  • Liquid funds also serve as an excellent alternative to the savings account, where one can earn higher liquid fund returns at relatively lower risk than other debt instruments.
  • These funds are ideal for investors who need cash but don't want to be exposed to market risks.
  • Liquid funds are also a good choice if you want to try out investing and grow your portfolio before moving on to more significant investments.

As per SEBI regulations, the minimum holding period for liquid funds is 91 days. These mutual fund schemes aim to generate returns by investing in highly liquid fixed income instruments with low risk while maintaining capital stability.

You can redeem your investment anytime without any exit load. Liquid funds returns are ideal for investors with a surplus amount that they do not want to invest in riskier assets.

Taxability of Liquid Funds

The taxability of the best liquid funds depends on the holding period. The holding period is the duration for which you have kept your money invested in a liquid fund.

According to the income tax slab, liquid funds are subject to capital gains tax if you sell the units within three years of buying them.

If you sell after three years, long-term capital gains (LTCG) tax of 20% per cent with indexation benefits will apply. Indexation means adjusting the purchase price of an asset for inflation using the cost inflation index (CII).

If you have redeemed your investment for three years, the total returns will be added to your income and taxed according to the income tax slab rate. After three years, 20% of the interest earned will be taxed at 20% if you have redeemed investments.

Risks involved with Liquid Funds

Liquid funds returns also carry a risk of capital erosion and the possibility of negative returns. This happens because the NAV of liquid funds is net asset values (NAV) that fluctuate daily. However, since these funds invest in short-term money-market instruments, the chances of their NAVs going down are minimal.

The stability of the NAV is directly dependent on the interest rates in the economy. When interest rates rise, the yield on liquid fund investments reduces, which results in a drop in the NAV. When interest rates fall, the yield on liquid fund investments increases the NAV.

When interest rates fall, debt funds have to mark down their portfolio securities to market prices. The extent of this markdown depends on how long each security has until maturity. This results in a negative impact on returns for investors holding these funds and those redeeming their money from these funds.

The primary risk associated with the best liquid funds is credit risk. This means that if an issuer defaults on its debt obligations, it can negatively impact your return from the fund or even lead to capital erosion if you have invested a substantial portion of your corpus into that particular fund or scheme.

Advantages of Liquid Funds

  • A liquid fund is an investment that gives the convenience of a savings account and access to a checking account, but with a higher interest rate than if you kept your money in either.
  • Liquid funds diversify your investment across different companies to don’t have all your eggs in one basket.
  • Since the investments have low maturity periods, the issuer has less risk of default. The NAVs of these funds are not affected by interest rate changes since they only invest in short-term instruments.
  • Since investments are made in debt instruments with low maturity periods, you can redeem your investment quickly at any time.

Liquid funds are tax-efficient as short-term capital gains on redemption within three years are taxed at the investor’s marginal tax rate. After three years, long-term capital returns are taxed at 20% with indexation benefit.