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Liquid funds meaning

Liquid Funds are debt mutual funds that invest in debt instruments to yield a predictable return and mature in 91 days. Liquid Funds are money market instruments like certificates of deposit, treasury bills, and commercial papers. There is no lock in period for these funds and hence are highly liquid. The risk associated with liquid funds is least compared to other debt funds.

What are Liquid Funds?

Open ended debt mutual funds that invest in debt instruments to yield a predictable return and mature in 91 days are liquid funds. The debt securities they invest in are of high credit quality. They are money market instruments like certificates of deposit, treasury bills, and commercial papers with 91 days maturity. The NAV for liquid funds is calculated for 365 days, unlike other debt funds whose NAV is calculated for only business days. There is no lock in period for these funds and hence are highly liquid. The risk associated with liquid funds is least when compared to other classes of debt mutual funds. These funds do not have any entry or exit loads. These low risk funds give higher returns than a savings bank account.

liquid funds

What are the Types of Money Market Instruments?

Liquid Fund schemes invest in money market instruments. These are certificates of deposits, commercial papers, and treasury bills.

1. Certificate of Deposit

A deposit of money in a bank or a financial institution is a Certificate of Deposit (CD). It is similar to FD but differs in two ways. CD is only for large sums of money, and CD is freely negotiable. CDs are highly liquid, considered safe, and give returns higher than t-bills. CDs are issued at a discount, and the tenure ranges from 7 days up to a year.

2. Commercial Paper (CP)

An unsecured promissory note issued by high rated companies to meet short term capital needs by raising money from the market. The tenure ranges from a day to 270 days. The returns are higher than t-bills but not as secured as them. CPs are traded in the secondary market.

3. Treasury Bills

Treasury bills (t-bills) are issued by the central government and are one of the safest investment options available in the money market. These are zero-risk instruments, and hence the returns from these are not high. T-bills come with different maturity periods like 91 days, 182 days, and 364 days and are issued a discount to their face value. They are circulated by primary and secondary markets.

Who Should Invest in Liquid Funds?

Liquid funds are ideal for investors having idle cash lying in the banks and are looking to invest in short term instruments. A liquid fund gives more returns than a savings bank account. Hence, instead of parking the excess funds in a bank, investors can choose liquid funds.

When an investor has surplus funds in the form of bonus or capital gains, incentives, gifts from family, etc. can be invested in a liquid fund first. And later, using an STP (Systematic Transfer Plan) can be invested in equities and take advantage of rupee cost averaging.

What are the Things to Consider as an Investor?

1. Risk

 The risk relates to volatility in Net Asset Value (NAV) in mutual funds. Liquid fund’s NAV doesn’t fluctuate too much because the underlying asset’s maturity varies between 60 days to 91 days. Therefore, this prevents the fund’s NAV from too many fluctuations. However, the value of the fund might drop significantly when the underlying asset’s credit rating is suddenly downgraded. It implies that liquid funds are not entirely risk free.

2. Returns

Returns from the liquid fund are way higher than 4% returns offered by traditional savings bank accounts. Historic liquid funds returns have been in around 6%. No investment guarantees return. Similarly, liquid funds do not guarantee any returns; however, more often than not, liquid funds have yielded positive returns upon redemption.

3. Financial Goals

Investing in the right asset class based on financial goals is the best investment strategy. Liquid funds are best suited for parking cash for the short term. These funds are also suitable for creating an emergency fund. Not just for earning higher returns, but the redemption of funds can be done faster with liquid mutual fund schemes.

4. Investment Horizon

Liquid Funds are suitable for short term investments, say up to three months. Liquid mutual funds are meant for investing surplus cash rather than having them sit idle in a bank account. For longer investment horizons, i.e., beyond three months up to one year, ultra short term funds are an excellent option to earn relatively higher returns.

5. Cost

Liquid Mutual Fund schemes charge fund management fees and other fees related to operating the fund. The total cost is called the Expense Ratio. As per the new SEBI guidelines, the upper limit for expense ratio of Liquid Funds is 1.05%. Considering the fund manager’s strategy of holding the asset until maturity, liquid mutual funds maintain a low cost ratio to generate relatively higher returns over a short period.

6. Tax

Gains from debt instruments are taxed. The rate of tax depends on the investment duration in the debt fund. Investments held for a period of three years attract Short Term Capital Gains Tax (STCG), the earnings are added to the taxable income of the investor and are taxed as per the applicable income tax slab rate. While investments held for greater than three years, they are taxed at the Long Term Capital Gains Tax (LTCG) rate of 20% after indexation.

How to Choose Liquid Funds?

1. Historical Returns

Though past returns do not guarantee future returns, it’s a good indicator to understand the fund’s performance. Check whether the fund has consistently performed well over the years and outperformed its benchmark and category returns. If it has performed well in the past, it is expected that the fund will perform equally well in the future. The track record of the AMC also has to be checked before investing in a liquid fund.

2. Credit Rating

For Liquid funds, it’s necessary to check  the credit ratings given of the underlying assets. A high credit rating ensures minimum credit risk. Credit risk is the default risk of the security issuer. It is defaulting on the principal amount or interest payments. The highest rating given to any security is AAA, which ensures high credit quality.

3. Portfolio Allocation

Understand the various schemes and instruments in which the fund has invested.

4. Average Maturity of Portfolio

Look for the average maturity duration of the portfolio. It’s good to invest in Liquid funds with an average maturity of three months or less. Short term maturity ensures that the portfolio doesn’t fluctuate too much because of interest rate changes that happen in the long term.

5. Expense Ratio

Pick a liquid fund with a low expense ratio. Lower expense ratio increases the overall returns.

6. Fund Objective

Choose a plan amongst the growth plans, daily dividend, weekly dividend, and monthly dividend plans that best suit the risk appetite and investment objective.

When should you invest in Liquid Funds?

Investors can invest in liquid funds in the following circumstances:

  • When the investors have surplus funds.
  • When the investors have short term goals with tenure of 3 months.
  • When the investors are unsure of when they need the funds, and liquid funds are a better choice than a savings bank account.
  • When the investor wants to invest  surplus money in equity, but wants to take advantage of SIP.
  • Then the investor can invest a lump sum amount in a liquid fund and then do an STP to an equity fund.
  • Another popular investment practice is to maintain an emergency fund with living expenses for up to 6 months. Investors can park their emergency funds in the liquid funds to earn an extra return on it.

Tax on liquid funds

Returns from Liquid Funds are categorized as below for taxation purpose:

Short Term Capital Gains (STCG): If the Investment is made for less than three years,  short term capital gains are added to the investor’s taxable income and are taxed as per the applicable income tax slab rate. For example, if an investor earns INR 50,000 by investing in Liquid funds for three years, this amount is added to their taxable income, and the investor is taxed accordingly.

Long Term Capital Gains (LTCG): For investments held beyond three years, long term capital gains are taxed at 20%, with the benefit of indexation.

Benefits of Investing in Liquid Funds?

  • No Lock-in period: Withdrawals from liquid funds are fulfilled within 24 hours on business days.
  • No entry and exit loads: Unlike FDs, Liquid funds do not have any entry and exit loads (but you need to hold for at least 7 days).
  • Low interest rate risk: Liquid mutual funds have low interest rate risk as they are highly liquid and invest in instruments with high credit rating.
  • Diversification: Liquid funds offer good diversification for investor’s portfolio. Investors with excess cash can park it in liquid funds.

How to Invest in Liquid Funds?

  • Step 1: Sign Up/Sign In to Scripbox
  • Step 2: Scripbox has curated portfolios for investors for multiple needs. For liquid funds the Scripbox curated portfolio is “Be Emergency-ready”. Select this portfolio to invest in liquid funds.
  • Step 3: Review fund recommendations and Continue
  • Step 4: Provide contact details and date of birth
  • Step 5: Provide PAN details and complete e-KYC
  • Step 6: Decide how much to invest in the portfolio and invest in it. Happy Investing!

Top Performing Liquid Funds

The Best Liquid Funds 2021 recommended by Scripbox are:

  1. Axis Liquid Fund Growth
  2. Tata Liquid Fund Regular Growth

Frequently Asked Questions

What are liquid funds in India?

Liquid funds are a type of debt funds with a short term investment period. Liquid funds are flexible in nature with a zero lock-in period. These funds generally come with higher returns than the savings accounts. Liquid funds are parked for an emergency requirement and liquidity management. 

How do I redeem my liquid fund?

The liquid fund offers an instant redemption facility to its investors. Hence, one can withdraw up to Rs. 50,000/- per day from each fund. Usually, it takes about 1 to 2 days to proceed with your redemption request.

Can I invest a lump sum in liquid funds?

Yes, you can invest a lump sum amount in liquid funds. In order to earn high returns on your corpus start a Systematic Transfer Plan (STP) from debt fund to ELSS Fund. This will not only help you earn a high return on your corpus but also allow you to make a systematic investment. 

Is debt mutual fund risk-free?

Yes, debt funds come with various risks. Hence, one should keep in mind the risks associated with it before investing. With various debt mutual funds available in the market the risk associated with these funds also varies. Therefore, one should keep a close vigil on the interest rate risk, default risk, credit risk, liquidity risk and duration risk at the time of investing in debt funds. 
Though, investing in a debt fund with a shorter duration is considered much safer but debt mutual funds are not risk-free. The investor should choose the right debt fund as per his/her risk appetite and financial goal. Also, regular monitoring of the portfolio helps in keeping a check on the fund.

What is the exit load for liquid funds?

The SEBI has formalized graded exit load structure on liquid funds since October 2019.
As per the new structure, holding an investment for one day in the liquid fund would draw an exit load of 0.007%, for two days the exit-load will be 0.0065%, followed by 0.006%, 0.0055%, 0.0050%, 0.0045% on the third, fourth, fifth and sixth day respectively.
However, the exit-load from the seventh day onwards will be nil. 

What is the benefit of the liquid fund?

The following are some of the benefits of the liquid fund:
Higher Liquidity: Liquid funds offer higher liquidity as an investor is at liberty to have access to instant liquidity in times of emergencies. 
Fixed Returns: The interest rates are pre-determined in liquid funds. Hence,an investor gets the invested amount with interest which is fixed. 
Low Risk: In Liquid funds the interest rates are pre-determined hence the market volatility does not hamper the return which works best for investors with low-risk appetite. 
High Returns: Liquid funds generate higher returns than savings accounts or Fixed Deposits.
Tax Efficient: Liquid funds also come with tax benefits ie., there is no exit-load when an investor wishes to withdraw funds after 7 days.

Is Liquid Fund better than FD?

Owing to its high liquidity and higher returns, Liquid Funds are a better option than FD. Investors choosing liquid funds over a fixed deposit may have tax benefits on long term investments. These funds can offer higher returns than FDs for investors who have a lower risk appetite.
However, the return may be higher in Liquid Funds but the same depends largely on the market volatility.  While Fixed Deposit is a long term capital gain but the returns are fixed and do not change with the market conditions.

How does a liquid fund work?

Liquid Funds being Debt Funds are usually invested in short term assets like treasury bills, certificates of deposits, Government securities and commercial papers. This ensures capital protection and liquidity to its investors. Also, the maturity period of the instruments in a liquid fund is less than 91 days which does not affect the interest rate on maturity. Hence, liquid funds are a better option than savings accounts.

Are liquid funds tax-free?

Liquid Funds are a type of debt funds. Hence, these funds are subject to tax as applicable to debt funds. However, any fund invested for a short period of time is tax-free. But an investment held for more than three years comes under the long term capital gains which are taxable at 20% with indexation.

Can I invest in liquid funds on Saturday?

Yes, you can invest in a liquid fund on a Saturday. However, Saturday being a weekend one can only submit a request. But the processing of the same will start only on Monday.
Thus, to invest your money on a weekend you will need to create a request on Friday before the closing time of the fund house. The closing time of liquid fund on a weekend is between 1 Pm to 3 PM.