In terms of personal finance, liquid mutual funds have a unique position. They do not have the same level of excitement as equities funds, do not have the same tax benefits as certain government programs, and do not have the guaranteed returns of fixed deposits investments. However, they effectively handle some financial planning issues that other tools are unable to.
What Liquid Funds Really Do
A debt mutual fund that only invests in short-term debt instruments with maturities of up to 91 days is known as a liquid fund. The primary source of returns for the fund is interest income rather than changes in the underlying assets’ market prices.
Typical holdings include treasury bills, government securities, company commercial papers, bank certificates of deposit, and short-term corporate bonds. Even on weekends and holidays when markets are closed, interest in these assets causes the fund’s NAV to gradually grow every day.
In contrast to fixed deposits, where interest accumulates either quarterly or yearly, this accrual method is daily. Your investment in liquid funds increases daily depending on the interest that the underlying securities earn.
The short maturity profile minimizes price fluctuations. Interest rate fluctuations have little effect on the fund’s value since holdings mature in 91 days. Liquid funds are thus among the mutual fund types with the lowest risk.
Main Uses for Liquid Funds
1. Establishing an Emergency Fund
Two qualities are necessary for an emergency corpus: capital preservation and instant accessibility. Compared to most other options, liquid funds provide both more successfully.
The conventional advice is to have an emergency reserve of six to nine months’ worth of necessities. This amounts to ₹3–4.5 lakh for a family with ₹50,000 in monthly necessities.
Splitting this corpus into 30–40% savings accounts or bank fixed deposits and 60–70% liquid money is a sensible allocation plan. For a ₹5 lakh emergency corpus, this entails keeping ₹2 lakh in a savings account or FD and distributing ₹3 lakh between two liquid funds from separate AMCs, each containing ₹1.5 lakh.
In addition to the ₹2 lakh in the savings account, this structure offers ₹1 lakh in immediately accessible funds via the ₹50,000 instant redemption maximum from each fund. The additional ₹2 lakh from liquid cash comes in 1–2 business days for major crises that call for the whole corpus.
2. Short-Term Objectives: Less than Three Years
Objectives with shorter time frames than three years cannot afford the volatility of the stock market. The whole strategy might go awry if there is a market drop six months before you need the money.
Liquid funds are useful for objectives with a high probability of success, such as financing a wedding in 30 months, buying a vehicle in two years, or making a scheduled down payment on a house in 18 months.
The earnings from liquid funds will not significantly speed up the accomplishment of objectives. They usually provide 1% more than the current repo rate, which is between 6 and 6.5%. Savings accounts cannot reliably provide returns that are somewhat ahead of inflation while protecting capital, which is what makes them valuable.
3. Temporarily Parking Extra Money
Money that is awaiting deployment is held in liquid funds. This covers yearly bonuses, asset sales proceeds, earnings from stock investments, and any windfall that necessitates a final allocation decision.
As a default, many investors store these sums in savings accounts, earning 3–4% while they consider their options. During this time, liquid funds yield 6–6.5%, with minimum delay for bigger balances and the same liquidity for amounts up to ₹50,000 per fund.
Systematic Transfer Plans take advantage of this by moving set amounts into equity funds on a regular basis and storing bulk sums in liquid funds. Rupee cost averaging may be achieved, for instance, by investing ₹10 lakh in a liquid fund and establishing a ₹1 lakh monthly STP into an equities fund, with the remaining funds earning returns rather than being idle.
The Real Workings of Redemption
Up to ₹50,000 in Instant Redemption
Liquid funds provide actual quick redemption 24 hours a day, 365 days a year, including weekends and holidays, for balances up to ₹50,000. IMPS delivers the funds in a matter of minutes.
Your account receives a redemption request on Saturday afternoon. A request made on Sunday night is processed right away. This service is available on banking holidays and outside of market hours.
However, investing directly with the AMC or in Statement of Account manner is necessary for quick redemption. Units kept in demat form are not compatible with it. Before presuming quick access, check your investment mode.
Frequent Redemption Over ₹50,000
Standard mutual fund settlement cycles apply to amounts above ₹50,000. On business days, redemption requests settle on T+1, which means money arrives the next business day.
Since mutual fund transactions are only handled on business days, requests submitted on the weekends are handled as Monday submissions. Funds for a Saturday request are received on Tuesday after a three-day delay. On Tuesday, a Sunday request also gets funding; there is a two-day delay.
Please submit redemption requests by Friday at 3 PM to guarantee the cash arrive on Monday. This is important when budgeting for big items that cost more than ₹50,000.
Tax Treatment in Relation to Fixed Deposits
Although they might not always have lower tax rates, liquid funds provide tax deferral benefits over fixed deposits.
Even if you do not remove the interest, interest income from fixed deposits is subject to a yearly Tax Deduction at Source (TDS). On post-tax amounts, your capital compounds. After the yearly tax deduction, a 7% FD effectively accumulates at 4.9% for an individual in the 30% tax bracket.
Until redemption, there is no tax on liquid funds. The pre-tax rate applies to all of your capital. Only when you redeem do you become liable for taxes; at that point, you pay according to your income tax slab.
In line with FD taxation, both short-term and long-term capital gains from liquid funds are subject to taxes at your income slab rate. The only advantage is deferral, which permits compounding on the whole amount instead of post-tax amounts.
This postponement might result in significant changes over many years for investors in lower tax categories or those who intend to redeem in years with lower income.
Comprehending Liquid Fund Risk
Although they are not completely risk-free, liquid funds are often low-risk. When fund managers compromise credit quality in order to pursue larger returns, risk arises.
Look into why one fund routinely yields 7.5% while the majority of liquid funds yield 6.5%. Higher yields often indicate that the fund is holding lower-rated corporate bonds or commercial papers with ratings of AA+ or A2 rather than AAA and A1+.
A single default in a lower-rated security may wipe out months’ worth of additional income. When a fund holding commercial paper has a repayment default, its NAV instantly decreases. It takes months or years to recover that principal via the judicial system.
Liquid fund rates should remain within 1% of the repo rate, according to a suitable benchmark. Liquid funds yielding 6.5–7.5% currently function within safe bounds, with the repo rate hovering around 6.5%. Anything much higher calls for caution.
Credit quality should always take precedence over variations in marginal returns. The purpose of liquid funds is not to maximize returns but rather to preserve capital and maintain liquidity. They serve no purpose by taking on credit risk in an attempt to get an additional 50 basis points.
In Conclusion
Knowing what liquid funds perform well and poorly can help you decide whether or not to include them in your financial strategy. Liquid funds should play a part for the majority of investors who have emergency funds, short-term objectives, or sporadic extra cash. Others could benefit more from using various instruments.
