What are liquid funds in mutual funds?
Liquid funds are often touted as a good replacement for bank savings accounts and fixed deposits. They are said to have low risk and are perfect for risk-averse investors.
Here is a detailed guide to help you learn everything you can about liquid funds and what you should know before investing in liquid mutual funds.
What Are Liquid Funds?
Liquid funds are debt funds that invest in fixed-income securities such as certificates of deposit, treasury bills, commercial papers, and other debt securities that mature within 91 days.
Liquid funds do not come with a lock-in period. These funds carry less risk and are considered to be the least risky among all classes of debt funds.
The reason they are less risky is that they mostly invest in high-quality fixed-income securities that are going to mature soon. Hence, these funds are suitable for risk-averse investors.
Unlike some other funds, the Net Asset Value (NAV) of a liquid fund doesn’t fluctuate much and that’s why low duration high-quality securities make up these funds.
If you wish to withdraw your investments from a liquid fund, the withdrawals are typically processed in 24 hours.
How Do Liquid Mutual Funds Work?
When you invest in a liquid mutual fund before 2 PM of a trading day, it will be processed as per the previous day’s Net Asset Value (NAV), as long as the funds are credited to the asset management company’s (AMC) collection account before 2 PM and the application reaches the AMC’s branch before time. So, if a purchase transaction in a liquid fund is submitted on T day, the applicable NAV is of the day prior.
When you redeem your investments from the liquid fund, the redemption will be credited to your account on the next working day.
For example, if you make redemptions on Friday before 3 PM, the redemption will be processed on Sunday’s NAV and the payout will happen on Monday.
The main source of earnings of a liquid mutual fund is via the interest income of its debt holidays and a smart portion of its income may be generated through capital gains.
This means that when interest rates fall, bond prices go up and vice versa.
Who Should Invest In Liquid Funds?
Liquid funds are suitable for risk-averse investors, as the fund invests mostly in high-quality securities. If you have any surplus funds, you can consider parking them in liquid funds and earn better returns.
What Should You Know Before Choosing Liquid Funds?
Objectives Of The Fund – Liquid funds are the least risky among all classes of debt funds because the NAV doesn’t fluctuate too frequently because the assets the fund has invested in have a maturity period in the range of 60 days to 91 days.
But, the thing you should remember is there might be a chance of a sudden drop in NAV because of an abrupt fall in the credit rating of the underlying security.
The moral of the story is that risk funds are not completely risk-free but they are safer than other types of mutual funds.
Risk Involved – Although liquid funds are touted as an alternative to FDs, they are a tad bit risky as the returns are not guaranteed. However, due to their low duration and short maturity as compared to other funds, they are less sensitive to changes in interest rates.
So, even if they are not completely without any risk, the top liquid mutual funds carry very minimal risk.
Returns – Historically, liquid funds have offered returns in the range of 7% to 9%, which is higher than the 3.5% interest provided by a regular savings bank account. However, returns are not guaranteed.
Cost – Like every other mutual fund, liquid funds also attract a fee, called an expense ratio. Liquid funds maintain a lower expense ratio to provide comparatively higher returns over a short period.
Benefits Of Investing In Liquid Funds
Better Returns – As mentioned before, liquid mutual funds earn higher returns than bank deposit rates. So, if you are willing to take a little bit of risk, you can consider investing in liquid funds.
Tax Benefits – Liquid funds follow debt taxation and their holding period is 3 years. When you redeem after 3 years, you get the benefit of indexation, which increases your purchase price. When your purchase price rises, your profits decrease. This helps you lower your tax payable.
High Liquidity – Liquidity refers to how quickly an asset can be converted into cash and liquid funds are highly liquid. If you redeem your investments from liquid funds, they will be processed in *T+1 day (*T = Transaction Day). For example, if you redeem on Friday, the redemption amount will be credited to you on Saturday. You can even redeem your investments from liquid funds after just investing for one day.
Low Exit Loads – Liquid mutual funds have exit loads of less than 7 days. This means you can redeem your investments from liquid funds without any penalties within just 7 days.
Low-Interest Rate Risk
We all know that debt funds carry interest rate risk. However, liquid fund papers mature within 91 days. Hence, they are not heavily affected by interest rate fluctuations. The NAV of liquid funds fluctuates very less compared to equity funds.
Perfect For STP – Liquid funds are a good option if you are considering doing a Systematic Transfer Plan into equity funds. In an STP, a fixed amount will be transferred from a liquid fund to an equity fund to achieve cost-averaging. You can also earn higher returns on the liquid fund balance.
Low Expense Ratios – Since liquid funds carry very low expense ratios, they offer higher returns.
Minimum Investment – Liquid funds are easier on the pocket than bank fixed deposits. If you start a bank FD, you would need to invest a minimum of ₹5000. However, you can start investing in a liquid fund with just ₹100.
Flexibility – Liquid funds come with growth and dividend options. If you are looking for capital appreciation, you can choose the growth option.
Meanwhile, if you want regular income, you can choose the dividend option. However, dividends are taxable when it reaches you. So, if you fall under the highest tax bracket, you might end up paying more tax when you choose the dividend option.
Taxes To Pay
When you invest in liquid mutual funds and withdraw the amount before three years of investment, you would have to pay the short-term capital gains tax (STCG) as per your income tax slab.
For example, if you earned ₹30,000 from your investment in liquid funds, ₹30,000 is added to your income tax slab and you will be taxed accordingly.
If you withdraw your investment after 3 years of investment, you would have to pay the long-term capital gains tax (LTCG), which will be 20%, with the benefit of indexation.
Let’s Start Investing…
Liquid mutual funds are a great short-term investment option and a profitable alternative to bank savings account and fixed deposit.
You can invest and redeem within just 7 days, without having to pay any penalties. It is convenient and your money can be accessed anytime by you.
If you are looking for the perfect platform to start investing in liquid mutual funds, you can head over to Koshex right away and start your investment journey.
Creating an account takes less than 2 minutes and no paperwork is required. What are you waiting for?
Head over to Koshex and create an account with us today!