Why Liquid Funds are a good option to park your idle funds
Many investors have substantial amounts lying idle in their savings bank accounts. Interest on savings bank balance is currently around 2.7 – 3%. Savings bank interest is taxable under the head “Income from other sources”. You can avail deduction of up to Rs 10,000 under Section 80TTA. Thereafter, the interest will be added to your income and taxed as per your income tax rate. Liquid funds can provide much better yields on your idle funds and at the same time offer high liquidity also.
What are liquid funds?
Liquid funds are debt mutual fund schemes which invest primarily in money market instruments like treasury bills, certificate of deposits, commercial papers, etc., that have a residual maturity of less than or equal to 91 days, with the objective of providing investors an opportunity to earn more returns on very short-term deposits, high degree of capital safety and liquidity.
Benefits of liquid funds
Superior short term yields: Rising yields, especially towards the shorter end of the yield curve has made 3 month yields quite attractive. Yields of 91 day Treasury Bills in RBI’s November auction was 6.44% (source: RBI). Yields of 1 month and 3 months Commercial Papers and Certificates of Deposit are 6.7 – 7.2% (source: CRISIL). You can get much better returns on the idle funds lying in your savings bank account by investing them in liquid funds.
Liquidity: Since liquid funds invest in papers which mature within 3 months they have high Moreover as per SEBI’s circular on risk management framework for liquid and overnight funds (2019), liquid funds must hold 20% of their assets in liquid assets (i.e. assets which can be very quickly converted in cash). According to SEBI’s definition of liquid assets, they are cash, Treasury Bills, Government Securities and repos on Government Securities (e.g. TREPs, CBLOs). As such, these funds are highly liquid.
High degree of safety: Since liquid funds invest in very short maturity instruments, the price sensitivity of these instruments to interest rate changes is extremely low. In other words, liquid funds have low interest rate risk. SEBI has also initiated some regulatory measures to reduce the credit risk in liquid funds. As mentioned earlier, SEBI has mandated that 20% of the AUM of liquid funds will be held in risk-free instruments like Government Securities, Treasury Bills, TREPs, CBLOs and cash. Among other papers, SEBI has also capped exposure to single sectors at 20%. These measures will make liquid funds safer from a credit risk
Low Risk: A liquid fund is a low-risk debt fund which focuses on providing safety of principal and steady returns. As a result, the value of a liquid fund is fairly stable across different interest rate cycles in the market. In contrast, funds holding longer‐maturity securities can swing between earning strong capital gains when rates are declining, to making heavy capital losses when rates are rising.
Low cost: Liquid funds are low-cost debt funds, mainly because they are not as actively managed as some of the other debt funds. In practice, most liquid funds operate with expense ratios below 1%. This low‐cost structure allows them to maximize the effective return to the investor.
Flexible holding period: An investor in a liquid fund can hold his or her investment for as long as necessary. Though a small exit load is charged for redemption within seven days, liquid funds have flexible holding periods. This makes it easy to enter and exit the investment while earning safe, market‐linked returns for the duration of the investment.
Quick Redemption: Redemption requests are processed within one working day; some funds even offer an instant redemption facility. This is possible as liquid funds are invested in highly liquid securities with a low default probability.
How to invest in Liquid Funds?
Investing in liquid funds is very simple. If you are KYC compliant, you can invest in liquid funds by filling an application form where you provide personal, investment and bank details. You can do this online or submit the application form at the offices of AMC or the Registrar and Transfer Agent (RTA). If you have an existing folio, then the online investment process is very simple; you simply need to provide the investment details and complete the transaction using net banking. Please note that the Net Asset Value (NAV) cut-off time for liquid funds is 1:30 PM. If your subscriptions (online / offline) is received by the AMC / RTA within the above time frame, then units will be allotted to you based on the current day’s NAV. For subscriptions received after 1:30 PM, next day’s NAV will be applicable. Consult with your mutual fund distributor if you need any help on this.
Liquid fund redemptions
As per SEBI’s guidelines liquid fund redemptions must be processed by T+1. The NAV cut-off time for liquid fund redemptions is 3 PM. This means that you should place your redemption request before 3 PM, if you want to funds to be transferred to your bank account on the next day. As mentioned before, some AMCs provide instant redemption facility for liquid funds. Please consult with your mutual fund distributor or financial advisor to know about instant redemptions.
Systematic Transfer Plans
Systematic Transfer Plan (STP) is a mutual fund facility in which you can invest your lump funds in one mutual fund scheme (source scheme or transferor scheme) and then transfer systematically fixed amounts every month (or any other interval) to another mutual fund scheme (target scheme or transferee scheme). If you want to invest in an equity fund but are worried about market volatility, then you can invest in a liquid fund and transfer systematically to the equity fund using STP. By investing using STP you can take advantage of market volatility through Rupee Cost Averaging (RCA) and at the same time get yields on the funds in your liquid fund account.
Taxation on Liquid Funds
Investors earn dividends and capital gains from liquid funds. Investors do not pay any tax on dividend income from mutual funds. In case an investor earns a capital gain- by redeeming the units of the fund at a price higher than his or her purchase price- then the capital gains are taxable.
- Short term capital gains: If an investor sells or redeems the units of a liquid fund after a holding period of up to 3 years, he or she is deemed to have earned short‐term capital gains. This is taxed at the income tax slab rate applicable to the investor.
- Long term Capital Gains Tax:If a liquid fund is redeemed/sold after being held for more than 3 years, the capital gain is treated as a long-term capital gain, and the investor gets the benefit of “indexation.” This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. Long term capital gains are currently taxed at a rate of 20%.
How to Find the Best Liquid Fund
In evaluating a liquid fund, the main criteria of analysis include returns, expense ratio, fund size, and extent of portfolio diversification.
- Returns: Since liquid funds invest in short term debt with maturities up to 91 days, investors should look at one-month or three-month returns to measure fund performance. Returns over a longer horizon (one/three years) are not meaningful for a liquid fund. A well-performing liquid fund should beat its benchmark as well as its peer funds, but investors must also verify that the fund has done well consistently. This can be checked by looking at one/three-month returns over the past few years.
- Expense Ratio: There is not much variation in the returns earned by liquid funds from different fund houses, because all these funds invest in similar short-term debt securities. Hence it is necessary to compare their expense ratios, which is the annual amount charged by the fund for managing the investment portfolio. The higher the expense ratio, the lower the final net return to the investor.
- Fund Size: Liquid funds are largely used by institutional investors. In case of a sudden large redemption by an institutional investor, a small liquid fund would lose a significant part of its assets, which in turn would adversely impact its ability to invest and generate returns. Hence liquid funds with relatively larger assets under management (AUM) are preferable to small-sized funds.
- Portfolio Diversification: Liquid funds are held for their ability to keep the invested corpus safe and stable. Thus, investors should evaluate the portfolio of a liquid fund to ensure that it is invested in several securities across different issuers. This will minimize the damage to the portfolio in case of default by any issuer.
Who should invest in liquid funds?
- Investors who want to park their idle funds for a few weeks or a few months.
- Investors who want high liquidity and high degree of capital safety.
- Investors who want to invest in equity funds through STP from liquid funds.
- Investors who can remain invested longer than 7 days, otherwise exit loads may apply.
Investors should consult their mutual fund distributors, if liquid funds are suitable for their short term investment needs.
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-CA JAYESH GANDHI
Disclaimer: This is an informative document and opinions expressed in it are our own and not any advice. We are AMFI registered MUTUAL FUNDS DISTRIBUTOR.
