What are Liquid Mutual Funds? Benefits, Risks, Instruments and Taxation on Liquid Funds
Liquid funds are a flexible investment option as a type of debt fund. They invest in debt and money market instruments, typically maturing within 91 days. This short-term nature allows you to park surplus funds for a few weeks to a few months, empowering you to make strategic investment choices. This article will provide a list of the top liquid funds, fund overviews, and guidance on investing in them, further empowering your investment decisions.
What are Liquid Mutual Funds?
Liquid mutual funds in India are debt funds that provide short-term loans to businesses for up to 91 days. Due to their short loan tenure, these funds are considered the safest among all mutual fund types. They have no lock-in period, and redemption requests made on business days are processed within 24 hours.
Liquid funds generally invest in high-quality, fixed-income liquid securities that mature quickly, making them a low-risk option for investors. Although the returns are market-linked and can occasionally be negative, this is rare since these funds typically invest in low-risk, short-term assets.
What are the Underlying Instruments of Liquid Funds?
Liquid funds invest in instruments that typically mature within 91 days. As a result, their returns can be lower than those of other debt instruments with a longer maturity period, such as short-term funds, ultra-short-term funds, and low-duration funds. However, under common circumstances, liquid funds give better returns than overnight funds. They also typically offer better returns than bank interest rates and, thus, can be a suitable alternative investment option for investors.
How do Liquid Funds Work?
To understand liquid funds, knowing their investment strategies and how they generate returns is crucial.
- Investment Strategies of Liquid Funds: Liquid funds invest in short-term, high-quality, highly liquid securities. SEBI’s guidelines reinforce these features by allowing investment only in listed commercial papers and limiting sector exposure to 25%. They cannot invest in risky assets as defined by SEBI, which helps mitigate credit risk. Additionally, liquid funds must hold at least 20% of their assets in liquid products like cash and money market securities to meet redemption demands quickly.
- Earnings Sources: Liquid funds primarily earn through interest on debt holdings, with minimal income from capital gains. This is due to the inverse relationship between bond prices and interest rates, which is more pronounced for long-term bonds. Since liquid funds invest in short-term securities, their market value is less affected by interest rate changes, leading to low capital gains or losses. In a rising interest rate environment, liquid funds can outperform other debt funds because their interest earnings increase, and their market values experience limited capital losses, resulting in low-interest rate risk.
Who Can Invest in Liquid Funds?
- Liquid funds offer higher returns than bank deposits for short-term investments, making them a better option for those seeking minimal risk.
- These funds invest in assets that expire within 91 days, so they are ideal for investors looking to stay invested for up to three months.
Features of Liquid Funds in India
Here are the key features of liquid funds in India:
- Returns: Liquid funds generally offer higher returns than traditional savings accounts or fixed deposits, typically ranging from 7%-9%. These returns can vary based on portfolio management and expense ratio.
- Easy to Invest: You can start investing in liquid funds with as little as Rs 1,000.
- High Liquidity: Investments can be redeemed within 24 hours, making them ideal for emergencies.
- Variety of Options: Several categories are available, allowing you to match your investment with your risk tolerance.
- Taxation: Liquid funds have a favourable tax structure, with long-term capital gains taxed at 20%, similar to savings accounts.
- Low Risk: These funds invest in high-rated short-term instruments, resulting in lower risk.
- No Lock-in Period: Liquid funds offer immediate liquidity, making them a flexible option for meeting financial needs without a lock-in period. Liquid funds offer flexibility in terms of holding periods. They can be used for both short-term investments and longer-term emergency funds.
- Financial Goals: They are useful for building emergency funds, providing higher returns and easier liquidity than bank accounts.
- Costs: Liquid funds charge an expense ratio for managing the funds, capped at 1.05% by SEBI.
How to Invest in Liquid Funds?
Investing in liquid funds can be a relatively simple process and can be done in a few easy steps. Here’s a step-by-step guide:
- Open a Demat Account: To invest in liquid mutual funds in India, you must have a demat account. You can open a Demat account with a registered stockbroker or through an online platform that provides demat account services, like smallcase!
- Select a Fund: You may choose liquid investments that suit your needs and financial goals. Several funds are available in the stock market. You can research and compare their returns and portfolio composition and use tools like the Tickertape Mutual Fund Screener to learn more about the liquid funds that interest you.
- Fill in the Application Form: After selecting a liquid mutual fund, you should fill in the application form provided by the mutual fund house, AMC website or the investment platform through which you want to invest.
- Provide KYC Documents: To complete the investment process, provide your KYC documents, such as your PAN card, Aadhaar card, and bank details. You can also complete the KYC process online through various platforms.
- Invest: After completing the KYC process, you can invest in the liquid fund through net banking, debit card, or cheque payment. You can invest a lump sum amount or opt for a Systematic Investment Plan (SIP) to invest regularly.
Advantages of Investing in the Best Liquid Funds
Here are the advantages of the best liquid funds in India that you might find helpful.
- Cost-Efficiency: Liquid income program funds can be less expensive than actively managed debt funds. Their lower expense ratio may result in a relatively higher take-home return.
- Lower Risk: They tend to have lower risk levels because the underlying securities typically mature within 91 days. This might reduce the potential for volatility in these funds.
- Flexibility: As open-ended mutual funds, they may offer the flexibility to redeem your units at your convenience. However, it’s important to note that a small exit load may be imposed if you redeem within seven days from the date of allotment.
- Efficient Processing: Redemption requests are typically processed within one working day. In some cases, certain they may offer the option of instant redemption.
Risks of Investing in Liquid Mutual Funds in India
Short-term liquid funds are a type of mutual debt fund with a maturity of up to 91 days. This can make them a relatively low-risk investment option, but there are still some risks to be aware of before investing. Here are a few potential disadvantages of liquid funds:
- Credit Risk: Although they typically invest in high-quality securities, there is still some risk of default, especially if the issuer’s financial condition worsens.
- Interest Rate Risk: They invest in short-term securities, so the impact of interest rate movements can be relatively low. However, if interest rates rise significantly, the value of the fund’s portfolio may decline, and investors may lose money liquid.
- Inflation Risk: Inflation risk is the risk that your investment’s purchasing power may decline over time due to inflation. This is because investments may offer lower returns than other types of investments; there is a possibility that your investment may not keep pace with inflation.
Taxation on Liquid Funds in India
Investors can earn capital gains and dividends through liquid funds. Capital gains are taxable when they redeem funds at a higher price than the purchase price.
Capital Gains
- Short-term Capital Gains (STCG): If investors redeem funds within three years, the gains are taxed per their income slab rate.
- Long-term Capital Gains (LTCG): If investors redeem funds after three years, a 20% tax applies with indexation benefits. Indexation adjusts the purchase price for inflation based on the government’s index.
Dividend Taxation
- Dividends are added to taxable income and taxed according to the investor’s income bracket.
- There is a 10% TDS on dividend amounts exceeding Rs. 5000 in a financial year.
The taxability of liquid funds depends on the holding period. Selling units within three years incurs STCG tax. After three years, LTCG tax applies with indexation benefits.
What are the Factors You Should Consider Before Investing?
Before investing or figuring out which liquid fund is best, it is essential to consider the following factors:
- Risk and Returns: Evaluate the fund’s risk and return profile and ensure it aligns with your liquid investment options and risk tolerance. These funds may offer relatively low-risk investment options with modest returns.
- Expense Ratio and Other Costs: Check the expense ratio and other costs associated with the liquid schemes, as they can impact your overall returns. Lower expense ratio funds may result in higher returns for investors.
- Minimum Investment and Exit Load: Check the debt liquid fund’s minimum liquidity investment amount and exit load before investing. Some funds may have a higher minimum investment amount, while others may impose an exit load if you redeem your investment before a specified period.
- Credit Quality of Underlying Securities: Check the credit quality of the underlying liquid securities in the fund’s portfolio. These typically invest in high-quality debt instruments with low credit risk, but checking their credit ratings is essential.
- Liquidity of the Fund: Check the liquidity of the liquid MF, as it is essential to ensure that the fund can meet your redemption requirements. Highly liquid fund units can easily buy or sell, which refers to liquidity.
To Wrap It Up…
In conclusion, liquid mutual funds in India can be a good investment option for investors who seek high liquidity and moderate returns with low risk. These funds invest in highly liquid debt instruments with a short maturity period, making them attractive options for individuals, corporations, and institutions with surplus cash balances. They may offer higher returns than traditional savings accounts and fixed deposits while maintaining a low-risk profile. However, it’s advisable to carefully consider the associated costs, taxation rules, credit quality of underlying securities, and liquidity of the fund before investing.
Frequently Asked Questions About Liquid Funds
Liquid money is an asset that can be easily converted to cash without losing value. It is the most accessible form of wealth.
Liquid money is cash or assets that can be easily converted to cash without losing value. It is the most accessible form of wealth.
No, liquid funds in India do not have a lock-in period. You can redeem your investment at any time without penalty.
Liquid beEs are exchange-traded funds (ETFs) that comprise bonds issued by Indian public sector companies. They can give investors low-cost exposure to a diversified portfolio of these bonds, enabling liquidity and income from periodic interest payments.
Yes, investors can opt for SIPs in liquid funds. SIPs can be a good way to invest in liquid funds because they allow investors to build wealth over time and reduce the risk of market volatility.
Certificates of deposit(CDs), treasury bills, and commercial paper are examples of liquid funds. These funds typically include instruments that have maturity periods of upto 91 days.
Mutual Funds Investments Guides on smallcase –
All about mutual funds, it’s types, taxation, NAV, apps for mutual funds just one click away, start your mutual funds and SIP Journey today on smallcase.
