Category : Investing Guides March 5, 20245 minutes read
What are liquid funds? Liquid mutual funds are an investment scheme that invest in short-term and liquid fixed-income securities with an investment horizon of 91 days. Liquid mutual funds are preferred by those who want stability and quick access to funds. They can be a good avenue for parking surplus cash. Some of the benefits of liquid funds include:
- Lower Risk
- Low Expense Ratio
- High Liquidity
However, they may also have certain disadvantages:
- Lower Returns
- Vulnerability to Inflation Risk and Credit Risk
- Vulnerability to Interest Rate Fluctuations
Introduction
In the realm of investment opportunities, mutual funds emerge as one of the popular options for all kinds of investors. Mutual funds come in various types and can help you meet a plethora of your goals. Under the category of debt mutual funds are liquid mutual funds. They stand out as a versatile and low-risk option for those who have a very short investment horizon.Liquid mutual funds are preferred by those who want stability and quick access to funds. They can be a good avenue for parking surplus cash. In this article, we delve into detail about what are liquid funds including the meaning of liquid funds, its benefits and disadvantages, liquid mutual fund returns, among other things.
The term ‘liquidity’ is often used when trying to analyze investments. Liquidity refers to how quickly and easily you can sell or redeem your investment and convert it into cash. When you make short-term investments, it is extremely important to ensure that they are liquid.
What is liquid money? In simple terms, liquid money or liquid assets are funds or investments that are available for immediate use. In case of an emergency, or when the time comes to meet your financial goal, it is essential to have this money at disposal.
However, that doesn’t mean your money cannot earn returns. Instead of holding excess cash in a savings account, where you may not earn much interest, investing it in instruments that give potentially higher returns can be smart. When it comes to understanding what is liquid money, checking some examples of liquid assets can help. Here are examples:
- Cash
- Bank deposits
- Certificate of deposits
- Commercial paper
- Treasury bills
- Short-term government bonds
The good part of liquid assets is that they can be quickly converted into cash without significant loss of value or too much delay.
What are Liquid Funds?
That’s where the idea of liquid funds or short-term liquid funds comes in. What are liquid funds? Liquid funds are a type of debt mutual fund schemes that invest in fixed-income securities. However, instead of long-term instruments, short-term liquid funds invest in securities such as treasury bills, commercial paper, certificates of deposits and bank term deposits. Usually, these instruments have a maturity of less than 91 days. The regulator mandates that liquid funds only invest in securities that meet this maturity period criteria.
Liquid mutual fund returns depend on the returns of securities. However, given the short liquid mutual fund maturity period, interest rates do not fluctuate too much, which means there may be potential to generate optimal returns. However, liquid mutual fund returns may be higher than savings returns or even fixed deposits.
Start investing in liquid assets with Bandhan Liquid Fund today.
What is Net Asset Value in Mutual Funds and How Is It Relevant to Liquid Funds?
Before delving further into what are liquid funds, you need to understand the net asset value in mutual funds. Net Asset Value or NAV represents a fund’s performance and helps assess the value of a mutual fund investment. It is calculated as the per-unit value of a mutual fund’s assets after subtracting its liabilities. NAV of a mutual fund is calculated daily.
The purchase and redemption of mutual fund units is linked to NAV. It also helps investors track the performance of their investments and calculate gains or losses. When you buy or sell your investment, the price per unit is arrived at by dividing that day’s NAV by the total number of units in the market.
The NAV of a mutual fund, including liquid mutual funds, is calculated using the following formula:
NAV = (Value of Fund’s Assets − Value of Fund’s Liabilities) / Total Number of Fund Units Outstanding
For short-term liquid funds, the process involves valuing the fund’s assets such as t-bills and commercial paper, at the current market price. Then, the valuation of liabilities, including outstanding expenses or payments is subtracted from the total value of assets. The NAV of the liquid fund is arrived at by dividing this by the total number of units held by investors.
Liquidity refers to how quickly and easily you can sell or redeem your investment and convert it into cash. Liquid assets such as cash, bank deposits, certificates of deposit, commercial papers, treasury bills and short-term government bonds are liquid assets that can be converted into cash quickly. Liquid funds are a debt mutual fund scheme that invest in fixed-income securities. However, instead of long-term instruments, short-term liquid funds invest in these short-term securities securities.
To fully understand what are liquid funds, it is imperative to get a grasp on how short term liquid funds work. A good liquid fund will invest in short-term debt instruments of good credit quality that are liquid.
Typically, a fund manager will research good short-term instruments with a maturity period of 30 to 90 days and diversify investments. Liquid mutual fund returns are primarily generated through interest payments on securities.
Understanding the capital gains on liquid funds is important not just to comprehend tax on liquid funds, but also how they work. For this, you need to learn how bond prices react to interest rates set by the Reserve Bank of India (RBI).
The RBI releases lending rate information every quarter. Bond prices and interest rates are inversely related. When interest rates rise, bond prices fall. When interest rates fall, bond prices go up. This plays a role when a fund manager wants to sell off bonds they hold in the investment portfolio.
However, long-term bonds react more to interest rate changes. Since liquid funds invest in short-term securities with a maturity of less than 90 days, they are less affected by interest rate changes. Their market rate does not fluctuate too much. This means that liquid funds do not have significant capital gains or losses. As a result, tax of capital gains on liquid funds is near to negligible. We will talk more about tax on liquid funds later.
Liquid mutual funds have very short-duration instruments in their portfolio. As we have already mentioned, these fixed-income instruments have a maturity period of less than 91 days. Typically, this is reflected in the portfolio of liquid mutual funds as well. The average maturity of the portfolio is typically around 30-90 days.
To further understand what are liquid funds we need to dwell into their benefits and disadvantages.
Advantages of Liquid Funds
There are many benefits of liquid funds:
Low Risk:
Liquid funds are considered to be relatively low-risk investments due to their short maturity and focus on high-quality debt instruments. This makes them less susceptible to interest rate fluctuations compared to longer-term debt funds.
Avoid risky investments by investing in low-risk liquid funds.
High Liquidity:
Investors can easily redeem their investments in liquid funds within a short time, often within 24 hours as well. This makes them suitable for emergency fund parking and short-term cash management.
Expense Ratio:
The expense ratio of mutual funds represents the cost to own and operate a mutual fund. It is expressed as a percentage of the fund’s average net assets. The higher the expense ratio, the more it will eat into your profit. Liquid fund expense ratio is generally lower compared to other mutual funds since the portfolio turnover is lower, and the management costs are relatively minimal.
Redemption Process:
Liquid funds offer instant redemption, allowing investors to withdraw their funds quickly. The redemption proceeds are typically credited to the investor’s bank account within a business day if the investment is redeemed before 3pm of particular business day.
Holding Period:
While there is no mandatory holding period, investors often use liquid funds as short-term parking solutions. They can hold the investment for as long as they need the liquidity without incurring penalties.
Typically, tax on liquid funds is based on capital gains on liquid funds. If you earn a return on your liquid fund investment, then you will have to pay capital gains tax. New rules have simplified this – irrespective of how long you hold your investment, capital gains on liquid funds are taxed at your income tax slab. There is no dividend tax or any other tax on liquid funds.
Disadvantages of Liquid Funds
Like all investment instruments, there are some disadvantages of liquid funds as well. Keep these in mind before investing:
- While liquid funds returns may be higher than traditional savings accounts and FDs, they typically have lower returns compared to equity funds. This makes them unsuitable for long-term investments.
- Since liquid funds invest in relatively low-risk debt securities, they might not always keep pace with inflation, potentially eroding purchasing power over time.
- While liquid funds usually invest in high-quality debt, there’s still a possibility of default by the issuers of these securities. Always check the credit rating of all instruments that the fund holds.
- Although liquid funds invest in short-term securities, they are not entirely immune to interest rate fluctuations. A sudden change in interest rates could impact the fund’s performance.
Liquid funds have several benefits. They are a low-risk and highly liquid investment option. They may have a relatively low expense ratio. Liquid funds have a short-term holding period and offer instant redemption which may be convenient for investors seeking short-term and liquid investments.
Liquid funds may have disadvantages such as lower returns compared to equity funds. They may not keep pace with inflation and potentially erode purchasing power over time. There may be a possibility of credit risk and interest rate risk.
Now that you know what are liquid funds and some of the benefits of liquid mutual funds, it’s time to consider who should invest in these instruments. Liquid funds are suitable for investors seeking short-term liquidity, safety of capital, low risk and potentially higher returns.
- Liquid funds can be great to build an emergency fund. They may offer potentially higher returns than traditional savings accounts and have high liquidity.
- Investors with surplus cash who are not ready to invest in equities yet can park their money in liquid funds as a stopgap.
- If you are an entrepreneur or even run an institution, your short-term funds can be parked in liquid funds instead of cash. You can liquidate when you need to pay bills, salaries, or expenses.
- You can also include liquid funds in your wider portfolio for diversification.
Build an emergency fund by investing in liquid assets. Start investing with Bandhan Mutual Fund today.
How Different Are Liquid Funds From Other Investments
While explaining what are liquid funds, we have mentioned that liquid fund returns may be higher than savings accounts and FDs. It is now time to learn more about how liquid funds are different from debt funds and FD:
| Criteria | Liquid Funds | Debt Funds | Fixed Deposits (FDs) |
| Investment Type | Short-term debt instrument investing in securities with maturity of less than 91 days | Diverse debt instruments including short-term and long-term | Term deposit with a bank |
| Risk | Low to moderate; less than long-term debt funds and equity funds | Low to moderate; less than equity funds | Low |
| Maturity Period | Very short-term (30-90 days) | Short to long-term | Fixed term – can be days, weeks, months or years |
| Liquidity | High (Quick Redemption) | Moderate (Varies by fund) | High |
| Returns | Moderate | Moderate | Low, fixed returns |
- Investment Objective and Time Horizon: Before investing in liquid funds, ensure you know what your investment objective is and the duration for which you plan to invest in liquid funds.
- Fund Manager Expertise: Fund managers dictate the potential returns on your investment. Evaluate the expertise and track record of the fund manager.
- Expense Ratio: Consider the liquid fund expense ratio, a lower expense ratio can have a positive impact on your overall returns. Since potential liquid fund returns are anyway modest, cost cutting is important.
- Historical Performance: While past performance is not a guarantee of future results, reviewing the historical performance of the liquid fund returns can provide insights into its ability to deliver returns.
- Credit Quality: Understand the types of debt instruments the fund invests in and the credit quality of its holdings. It’s important to ensure that the fund maintains a prudent mix of issuers to mitigate credit risk.
How to Invest in Liquid Funds?
Investing in liquid funds is simple. You can choose a fund you like and choose the Asset Management Company. Complete KYC requirements, create a Folio and begin investing! After investing, make sure to monitor returns.
- Liquid funds can be a great investment for short-term financial goals. Now that you have read through the whole guide, you should have a fair idea of what are liquid funds.
- Liquid funds are debt funds that invest in fixed-income securities with very short durations. They are ideal for short-term investment goals like building an emergency fund or waiting for good market conditions for equity investing. The liquidity aspect, or how quickly and easily you can sell liquid funds makes them very attractive.
- Liquid fund maturity period is usually of less than 91 days. Liquid fund interest rate (liquid fund returns) may be relatively low, but it may be higher than savings accounts and fixed deposits. There are many benefits of liquid funds, including:
- Low risk
- High liquidity
- Relatively low expense ratio
- Instant redemption
- However, there are also disadvantages of liquid funds that you should consider before investing. Always check the fund’s performance, fund manager’s history and your own financial goals before investing in liquid funds.
