Liquid Funds: A Safe Bet?

There often arrive situations in our life when there is an urgent need to have cash on hand. If your investment is in fixed deposits, there is of course the option of terminating them and transferring the amount to your savings account but this is accompanied by penalty due to premature withdrawal. On the other hand, liquid funds offer not only a route to safe investment but the process of withdrawal is quick and without much loss to your principal amount. Rakesh Deshmukh takes a closer look at how liquid funds can be a dependable source for emergency funds while also earning a decent rate of return.  

The importance of liquidity is something you likely realised during the corona virus pandemic scenario. Keeping a portion of your savings in liquid form is crucial for everyone and is recommended for handling uncertainties. Generally, I have met two types of people in my lifetime: the first are those who keep money only either in a savings bank account or fixed deposit. The second group directs all their savings into various instruments, some with a lock-in period and others for the long term, often forgetting to keep a part portion in a liquid form that can be withdrawn at any time in case of an emergency. 

Liquidity doesn’t just mean being able to cash out anytime and anywhere. It also involves getting the real value of your assets. Let’s consider a simple example to understand this concept. You might have heard, or someone may have told you, that property or a house is not as liquid compared to mutual funds. The reason is that in a financial crisis, if you try to sell a property, you might find a buyer instantly but won’t get the right value for it. Alternatively, you might get the correct value but won’t find a buyer in a short period. 

Many a times, we encounter situations where we receive a lump sum amount of money for a specific period, often tied to pre-decided goals or events. In such cases, we usually prefer to keep it in a savings bank account. Another option we generally think of is a fixed deposit, but the idea of going to a bank, dealing with queues, and going through the process may deter us, leading us to simply keep the money in a savings account. Of course, nowadays fixed deposits can be booked and withdrawn online. Additionally, some banks offer monthly interest credits, which provide instant gratification when the amount is credited. 

One more reason for this might be that we are unaware of better options, and we often neglect the importance of preserving our money’s true value by earning returns that outpace inflation. Inflation not only makes goods and services more expensive but also erodes the purchasing power of your money over time. Therefore, simply keeping money idle in a low-interest account can result in losing value in real terms. And so, it is here that we must consider the role played by liquid funds. Remember, our focus in this article is on how to lay hands on cash in times of emergency. 

Defining Liquid Funds
Liquid funds are Debt Funds that invest in short-term assets such as treasury bills, government securities, repos, certificates of deposit, or commercial paper. According to the norms laid down by the Securities and Exchange Board of India (SEBI), liquid funds are only allowed to invest in debt and money market securities with maturities of up to 91 days. This strategy aims to generate optimal returns while ensuring safety and high liquidity. Redemption requests in liquid funds are processed within one working day (T+1), providing quick access to funds. 

The fund manager’s objective is to invest in highly liquid assets with strong credit ratings, minimising the risk of default. Investors often choose liquid funds to park their money for short periods, typically ranging from one day to three months. The net asset value or NAV of a liquid fund is calculated for 365 days. It is also important for investors to be aware of the current trends, such as whether other investors are withdrawing or investing money, as well as the AUM size of liquid funds in the industry compared to the total AUM size of debt-oriented schemes. The graph alongside indicates the monthly inflows trend and AUM. 

By observing the monthly data provided by the Association of Mutual Funds in India (AMFI), it is evident that liquid funds often experience outflows. Since a liquid fund is short-term oriented, outflows tend to be more frequent compared to equity funds, which are typically meant for long-term investments. Additionally, looking at the AUM of liquid funds, they contribute, on an average, 30 per cent to the total AUM of debt-oriented schemes. Additionally, the AUM of liquid funds has grown by approximately 16.38 per cent year-on-year (YoY), while the total AUM of debt-oriented funds has grown by 14.71 per cent during the same period. 

Timing the Choice of Liquid Funds 

When deciding whether to opt for liquid funds or explore other options, it’s important to consider your investment goals and timeline. We have already covered what liquid funds are and their advantages, but the key question is when should you choose liquid funds? Here are some situations where liquid funds may be the right choice: 

1. Investing for Short Investment Horizon: Liquid funds are ideal for those with an investment horizon of up to three months as they invest in securities with similar short-term maturities. If your investment horizon is longer, say six months to a year, you may want to consider slightly longer-duration funds to potentially earn higher returns.
2. Keeping Surplus Money in Bank Deposits: If you are someone who typically keeps surplus funds in bank deposits, liquid funds offer two main advantages: greater withdrawal flexibility and potentially better returns. Unlike fixed deposits, where funds are locked for a specific period and premature withdrawals are penalised, liquid funds allow easy entry and exit.
3. Planning for Contingency Fund: Liquid funds are well-suited for creating an emergency or contingency fund. These funds provide liquidity and safety while generating modest returns. Investors can be rest assured that their emergency corpus is easily accessible and safe, ready to be redeemed when necessary.
4. Temporarily Parking Funds: If you receive a large sum of money, such as a bonus, property sale proceeds or an inheritance, and are unsure where to invest it immediately, liquid funds are an excellent option. They serve as cash management tools, keeping your funds secure while offering some returns until you decide on a longer-term investment strategy.
5. Route into Equity Funds: If you want to invest in equity funds systematically, you can park your funds in a liquid fund and use a systematic transfer plan (STP) to gradually move money into an equity fund. This allows you to benefit from stable returns in the liquid fund while regularly investing in equities over time. 

Are Liquid Funds Safe Investment Options? 

As discussed at the beginning of the article, the importance of liquidity is something you likely realised during the corona virus pandemic. During this downturn, not only were the Indian markets falling sharply, but the global markets were also tumbling due to the crisis. As an assumption, let us say that you booked a profit of ₹1 lakh from your equity investments at a time when you thought the markets would dip on account of the pandemic and then re-invested the proceeds in liquid funds. What would have been the status of your investment? 

The above picture shows that if you had invested ₹1 lakh into liquid funds for three months during the market downturn, you would have earned around 1.47 per cent returns on that investment, which would have otherwise depleted due to your exposure on the equity side as Nifty 50 fell around 30 per cent during this three-month period. Remember, liquidity is not just about liquidating your assets and getting money but also involves obtaining the right value for them. Let’s consider that you invested the same amount on May 1, 2020, when the market was at a low point and held it for three months before redeeming it. The returns for that period are shown below. 

Does it make sense for the long term? Let’s figure it out. Instead of redeeming the above funds, what if you had remained invested till now? 

During this period, it would have delivered around 5.7 per cent, which is less compared to what equity funds might have delivered if you had invested the same amount in any equityoriented funds. Hence, we can say that a liquid fund is a good and, most importantly, safer option or a less risky instrument for parking surplus funds for a short duration. 

Fixed Deposit versus Liquid Fund
You have likely participated in or come across the following debate at some point: if one has to choose between fixed deposits (FDs) and liquid funds, what would be better? Every investor has their own unique circumstances, tastes and preferences. However, let us explore the major differences that you should be aware of. 

I would like to highlight the exit load on liquid funds, which is regulated by the Securities and Exchange Board of India. According to SEBI guidelines, liquid funds are permitted to impose a graded exit load over a seven-day period, structured as follows: 

Thus, the exit load on the fourth day was only ₹5.50 as illustrated above, which is a negligible amount compared to the penalty for premature exit from FDs. Interestingly, from the seventh day onwards, there is no exit load on liquid funds. On the FD side, there is a penalty for premature exit, typically ranging from 0.5 per cent to 1 per cent. So, if you exit an FD worth ₹1 lakh, the bank will charge you around ₹500 – ₹1,000. 

Interest Rates Risk on Liquid Fund Returns



Before diving into interest rate risk given that liquid funds are debt instruments and are associated with interest rate risk, it’s essential to understand their sources of earnings. Liquid funds primarily generate income through interest payments on their debt holdings, with a small portion of their income coming from capital gains. Bond prices and interest rates are inversely related: when interest rates rise, bond prices typically decline, resulting in negative returns for investors, and vice versa. 

Conversely, when interest rates fall, bond prices increase. This inverse relationship is particularly pronounced for long-term bonds, meaning that the longer the maturity of a bond, the more sensitive it is to changes in market yields. If there is a significant shift in interest rates, the value of these securities may experience changes. Since liquid funds invest exclusively in short-term securities, their market value is less affected by fluctuations in interest rates. As a result, liquid funds do not experience significant capital gains or losses. 

In a rising interest rate environment, liquid funds often outperform other debt funds because their interest earnings increase while their market values are impacted only to a limited extent by capital losses. It can be said that liquid funds have a very low-interest rate risk. Furthermore, liquid funds are not entirely protected to credit risk. Although they predominantly invest in short-term debt instruments with high credit ratings, there’s still a little possibility of default by the issuer. In such cases, the fund’s NAV may be adversely affected, impacting investor returns. 

Tax Consideration
You should also be aware of the taxation aspect of liquid funds in India. First, you must be aware about the cut-off date. If you purchased a debt fund, such as a liquid fund and conservative Hybrid Fund, before April 1, 2023, and remained invested for 24 months, the LTCG (long-term capital gains) tax of 12.5 per cent will apply. If sold within 24 months, the gains will be taxed as per your tax slab. However, if you invested in a liquid fund after the cut-off date, which is April 1, 2023, the holding period doesn’t matter here. Whether you sell before or after 24 months, both STCG (short-term capital gains) and LTCG will be taxed as per your applicable Income Tax slab rate. 

When Should You Avoid Investing in Liquid Funds?
1. Longer Term Horizon - If your investment horizon is longer than six months or a year, liquid funds may not be ideal as we have seen above. Over the long term, other investment options like equity-oriented funds or long-duration debt funds have the potential to generate higher returns compared to liquid funds, which focus on short-term safety and liquidity.
2. High Debt Contribution in Portfolio - If your portfolio already has a significant portion allocated to debt instruments, adding liquid funds might not provide additional diversification or better returns. Instead, diversifying into equities or other asset classes could enhance the growth potential of your portfolio.
3. Targeting Higher Returns - Liquid funds provide modest returns because they invest in short-term, low-risk debt instruments. If your goal is to maximise returns, you might want to consider riskier investment options like equity funds, which tend to outperform liquid funds over the long run.
4. Willing and Able to Take More Risk - If you are a young investor, say in your 20s, with a higher risk tolerance and the ability to endure short-term market fluctuations, you should explore higher-risk investments like equity funds, which offer better growth prospects compared to the relatively safer but lower-yielding liquid funds.
5. Money at Hand - Liquid funds may not be the right choice if you do not foresee any immediate need of cash. Liquid funds are designed for short-term parking of money and prioritise liquidity over returns. 

Conclusion
Liquid funds offer a modern approach to parking surplus funds, providing a more convenient alternative to traditional options like fixed deposits or savings accounts. Unlike fixed deposits, which often involve cumbersome procedures and penalties for premature withdrawals, liquid funds impose minimal exit loads within the first six days, and from the seventh day onward, there are no exit charges. Investing in liquid funds is hassle-free and can be done anytime, anywhere via mobile or laptop. Similarly, redemptions can be made conveniently online, with funds typically credited to your bank account within 24 hours, all without paperwork. 

"A mutual fund can do for you what you would do for yourself if you had sufficient time, training, and money to diversify, plus the temperament to stand back from your money and make rational decisions." - Venita VanCaspel (Author of best-selling books on financial planning)

Due to the short portfolio maturity, liquid funds carry minimal interest rate risk, as fluctuations in interest rates have a limited impact. Additionally, the portfolio comprises highly rated debt instruments, reducing credit risk. With attractive yields ranging from 6.5 – 7 per cent, liquid funds present a viable alternative to savings accounts, especially for those with a minimum investment horizon of three months. 

Moreover, liquid funds offer flexibility in withdrawals where you can choose to withdraw only a partial amount or redeem based on units, a feature often not available with fixed deposits. Given their structure, liquid funds are considered one of the safest mutual fund options as they lend to reputable companies for very short periods, thereby lowering the risk. Their returns are comparable to short-term fixed deposits, making them an effective alternative, especially since they offer liquidity without lock-in periods or penalties after seven days.