Liquid Funds are a kind of debt mutual funds that invest in securities with residual maturity of up to 91 days. As they are a type of debt funds, liquid funds primarily invest in debt and money market instruments such as bonds, debentures, Certificates of Deposit (CD), Commercial Papers (CP), and Treasury Bills (T-bills), etc. These funds are not market-linked and come with a short maturity period; hence, they offer high liquidity and are termed liquid funds. It is considered an ideal option to park the surplus money in liquid funds rather than in a savings account or fixed deposits.
Understanding Liquid Funds
Liquid funds, being a type of debt funds invest in fixed income securities that come with negligible risks. They invest in high-quality debt securities that come with residual maturity of 91 days only. During this short period, the NAV of the fund units does not fluctuate much because unlike equity funds they are not market-linked. Although debt funds bear interest and credit risks, there are very less chances of abrupt changes in the interest rate or credit rating of the underlying securities. They aim at providing a high degree of liquidity to investors and are considered one of the safest funds among mutual fund categories.
Taxation of Liquid Funds
Liquid funds are taxed as per the norms of debt funds, that is, returns are taken as short-term if held for less than 3 years. They are considered as long-term gains if held for more than three years. Short-term capital gains (STCG) are added to the income and taxed as per the income slab of the investor. Long-term capital gains (LTCG) are taxed at 20% with indexation benefits.
Why Invest in Liquid Funds?
Experts often suggest keeping a portion of their surplus income in liquid funds because of its multiple benefits such as below:
- Short Tenure
Liquid funds invest in short-term fixed income instruments and hence, it is easier for investors to park their money in these funds. Unlike the equity funds that are meant for long-term investments, these funds come with short-term maturity and are a great alternative to fixed deposits (FDs). They usually offer higher returns than FDs and come with higher liquidity. Experts often suggest building an emergency fund for unexpected contingencies in life and a liquid fund is a great option for it.
- Low Risk
Debt funds are low-risk funds as they are not market-linked; however, they do bear interest risks. While debt funds can be riskier when held for a long duration, the maturity period of 91 days of liquid funds makes them one of the safest options for investors. Liquid funds, because of their short-term underlying securities, have minimum risks. Moreover, they invest in high-rated money market instruments that further lower the risk levels.
- No Lock-in period
Even if liquid funds come with a 91 day maturity period, there is no lock-in period and hence, the redemption of units is easy. Investors can redeem their investments whenever they want as redemption requests are approved as quickly as in a day’s time. Some liquid funds also allow instant withdrawal up to a certain amount. There is no exit load on liquid funds after 7 days whereas there is a penalty charge for premature withdrawal from fixed deposits (FDs). This is a great advantage that liquid funds draw over FDs, other than having the potential to give higher returns than fixed returns of FDs.
- High Liquidity
With a short tenure and no lock-in, these funds offer high liquidity. This is perhaps one of the greatest reasons why liquid funds are considered a viable option for emergency funds. Moreover, adding a few debt funds along with equity investments diversifies the investment portfolio of a person. The perfect balance of short and long-term investments not only hedges against the risks but also serves both the purpose of wealth creation and emergency funds.
- Low Cost
The expense ratio of liquid funds is not very high because they are not so actively managed but invested in good quality and A-rated securities. With a low expense ratio along with the low cost (no exit load), they result in higher take-home returns.
Who should Invest?
Investors of liquid funds must consider the following factors:
- Invest if you are risk-averse as liquid fund risks are on the lower side
- If you are seeking a better option among safe investment avenues like fixed deposits, saving accounts, and debt funds. Liquid funds are more liquid and can provide better returns than FDs
- If you want to keep surplus money for emergency purposes, where you can gain some returns but there is no penalty charge on withdrawal. Liquid funds have easy redemption with no lock-in
- Liquid funds are not very ideal for investors aiming for wealth creation. Rather, liquid funds can be added to the portfolio to balance the risk side of equity funds
Wrapping it up:
Liquid funds, a kind of debt funds that allocate their assets to high credit-rated securities, are low-risk investments. These funds carry negligible vulnerability because of the least possible chances of fluctuations in short tenure. They are termed liquid funds because of their high liquidity owing to zero lock-in period and easy redemption of units. They are valued as a great alternative to fixed deposits because they are safe and have the potential to give higher returns than FDs. As the risks are low and they are highly liquid, these funds are deemed perfect for an emergency fund. Experts suggest that it is better to invest in liquid funds to keep the idle cash than in a savings account. It is also advisable to add liquid funds to balance and diversify the portfolio to hedge the associated risks with equity funds.