Liquid Funds

Apart from bank deposits, there is an even more lucrative option to meet your short-term investment needs - liquid mutual funds. Let’s explore what liquid funds are, how they work and if you should invest in them.

What are Liquid Funds?

Liquid Funds are a type of debt mutual fund. These funds pool money from investors to invest in debt and money market securities like Commercial Paper (CP), Treasury Bills (T-Bills), Certificate of Deposits (CD), etc. 

To give you context, corporate and government organisations issue commercial paper and treasury bills respectively to meet short-term funding needs. Liquid funds invest in these short-term securities, that mature in a very short period, typically a maximum of up to 91 days.

This means that a liquid fund manager invests only in securities where the borrower promises to repay the principal investment and interest within 91 days. Additionally, liquid funds process redemption requests within one working day (T+1), providing investors with quick access to their funds.

Best Liquid Mutual Funds

List of the top-performing liquid mutual funds sorted by returns with their AUM and Expense Ratio.

Why are these funds called ‘ Liquid Funds’?

The term ‘Liquid’ in finance reflects how easily an asset can be converted to cash without any loss in its value. Since liquid funds invest in securities that mature within 91 days, these are considered very low risk and almost as good as holding cash. 

Investors can access their money almost immediately when needed and there is a negligible loss in value. Liquid funds are built to provide a combination of safety and flexibility, making them ideal for short-term investments or parking surplus cash temporarily. 

How do Liquid Funds work?

Before we understand how liquid funds work let’s first understand the core concept of this process. Imagine you run a business where customers pay for their orders 30 days after delivery. 

However, to keep the business running smoothly, you need funds right away to pay your employees and purchase raw materials for your next batch of products.

To bridge this gap, you issue a short-term borrowing instrument called a Commercial Paper (CP), which promises to repay the loan within 30 days, along with a small amount of interest.

A liquid mutual fund manager sees this as a great opportunity. Since your business is financially stable and the payment from your customers is almost guaranteed in 30 days, the risk of default is very low. 

The fund manager pools money from investors and purchases your CP, providing you with the funds you need. When your customers pay you after 30 days, you repay the CP along with the interest. The liquid fund earns from this interest and passes the returns to its investors.

This is how liquid funds work. They invest in short-term debt instruments like CPs, treasury bills, and certificates of deposit that typically mature within 91 days, ensuring low risk and steady returns for investors.

What kind of debt securities do Liquid Funds invest in?

Liquid funds invest in short-term, high-quality debt securities that are designed to provide liquidity and low risk. When a company borrows funds on a short-term basis they issue a commercial paper. Similarly, when the Government borrows funds, they issue a treasury bill.

When fund managers invest in debt instruments they maintain strict checks to ensure that credit risk is as low as possible. They usually focus on instruments that have a high credit rating (AAA or AA+). These ratings indicate that the issuer has a very low likelihood of default.

Another important thing that every fund manager ensures is to diversify these debt instruments across T-Bills, CDs, and CPs from different sectors and issuers to reduce the concentration risk.

In conclusion, liquid funds focus on investing in safe and high-quality debt instruments to ensure liquidity and low credit risk. By employing rigorous checks and investing in government-backed securities, liquid funds try to deliver stable returns while protecting investor’s capital.

Should I invest in Liquid Funds?

When considering liquid funds as an investment, it's important to evaluate the following factors to determine if they align with your investment goals:

1. Short-term investment: These funds are a decent investment opportunity for investors seeking minimum returns within a short period. For example, say you have some idle funds but do not feel comfortable investing in funds that require you to hold your money for multiple years. In this case, something like a liquid fund that is easily redeemable and offers decent returns within a short period might be a good option.

2. Alternate to a savings account: Liquid funds also serve as an alternate investment to savings accounts. For instance, say you have ₹500,000 that you keep in your savings account. You earn a 3% interest on it annually. You can invest the same amount in a liquid fund and stand a chance of earning better returns. 

3. Temporary investments: Sometimes we have an influx of cash. Either a bonus or sale of an investment. In situations like this, we’re unsure where to park this money to get the most out of it. Let’s say you sold a property for ₹50,00,000. You are not sure whether to reinvest it immediately or use it for future opportunities. Instead of leaving the money in a savings account with low returns, you can park it in a liquid fund. While you decide on the best course of action, the fund generates a small return on your investment.

How much tax do I have to pay on Liquid Funds?

Like with any other investments, you are required to pay tax on any gain you make from liquid mutual funds. Two types of taxes can be levied. 

One is a short-term capital gain (STCG), which is levied when you hold your liquid funds for less than 24 months (2 years). 

The other is a long-term capital gain (LTCG), which is levied when you’ve held the fund for more than 24 months (2 years). You can read the tax implications for debt mutual funds here.

Tax on Dividends

Dividends from liquid funds are taxable in the hands of investors at their applicable slab rate from the financial year 2020-21. A TDS of 10% applies if dividends from a single asset management company exceed ₹5,000 in a financial year.

How to find the best Liquid Funds to invest in?

Even though Liquid Funds are one of the safest categories of investments, there are still checks you need to apply to see if it is the right fund for you. This includes checking:

1. Past performance: See how the fund has performed in the past, even though it is not an indicator of future performance it is still a good measure.

2. Credit Quality: Analyse that the securities that these funds invest in have a good credit rating and have less default risk

3. Fund Manager Record: Irrespective of the fund you invest in, you must know who your fund manager is and what expertise he holds.

You can know more about what other checks you need to apply in detail to look for the best debt mutual funds here.