Liquid Funds - Meaning, Risk, Returns, Benefits, Taxability, Best Funds

What are liquid funds?

Liquid funds are those debt mutual fund schemes that invest in high rated debt securities like certificates of deposits, commercial papers, T-bills & other money market instruments with short maturities of up to 91 days. Investments in government securities, & other corporate papers with high credit quality exposes these funds to very low risks. Moreover, these funds provide high liquidity to the investor as the investments can be redeemed very quickly on requests. This makes it suitable for investors to park their money for savings or creating an emergency corpus which can be withdrawn for emergency needs.

Investments in liquid funds are suitable for investors with low-risk appetite and an investment horizon of up to 3-6 months.

Liquid funds risks

Given that liquid funds make investments in debt securities, following are the major risks that a debt fund is exposed to:

1. Liquidity Risk: Liquidity risks is the risk associated with not being able to convert the securities or fund into cash at the required time.

As per SEBI requirements, liquid funds have to mandatorily invest in highly liquid debt securities that carry short maturities. This enables the liquid funds to be exposed to zero or negligible liquidity risks. Along with that from an investor’s perspective, the liquid funds allow quick and instant withdrawals on redemption requests which makes them a highly liquid asset.

2. Credit Risk: Credit risk is the risk associated with the defaults from the issuer on its interest or principal repayment obligations.

These liquid funds need to mandatorily make investments in high credit quality securities including those issued by government & corporates as well which ensures that there are very low risks associated with defaults in these funds. However, there might be some funds that would have taken undue credit risks for generating extra returns. So, investors should always look at the portfolio of a liquid fund before making any investments to avoid facing credit risks.

3. Interest Rate Risk: Interest Rate risks are the risks associated with the fluctuations in the returns or NAV of the fund in response to the interest rate movements in the market.

Liquid funds are also exposed to interest rate risks but to a very low extent when compared to other funds. Due to their low durations & maturities, the impact of interest rate movements on the fund is very low. The liquid funds follow the accrual-based strategy while investing which means they aim to earn fixed coupons from the underlying debt securities and also buy and hold the securities until maturity and therefore are less impacted by the interest rate movements.

Also Read: Hedge Funds - Meaning, Features, How are They Different from Mutual Funds

Liquid funds returns

Liquid funds generally provide stable returns on investments through their fixed interest earnings from the underlying debt instruments. The returns vary across the liquid fund schemes from different fund houses. Only returns should not be given preference while selecting the fund for investment, but also other factors like expense ratio, portfolio holdings, YTM, etc. should be considered to make the right choice.

Following are the return wise performances of some of the top funds in the liquid fund space over different tenures.

Fund NameAUM (Cr)3 Mth Ret (%)6 Mth Ret (%)1 Yr Ret (%)
IDBI Liquid Fund1,2641.072.665.57
Tata Liquid Fund - Regular Plan17,8581.002.565.41
Aditya Birla Sun Life Liquid Fund36,6791.082.545.44
ICICI Prudential Liquid Fund57,3351.042.535.40
Nippon India Liquid Fund30,6041.042.535.41
Axis Liquid Fund27,0320.992.525.40
Mahindra Manulife Liquid Fund - Regular Plan2,1441.022.485.43
Sundaram Money Fund - Regular Plan3,4680.962.405.27
Baroda Liquid Fund3,3730.842.395.28

as of 23 July 2020

Liquid funds taxability

Liquid funds have the following taxability for different tenure of investment holdings:

  1. If the units are held for less than 3 years, then the returns from liquid funds are treated as Short Term Capital Gains(STCG) for taxation purposes. These gains are taxed as per the income tax slab rate applicable to the investor.
  2. If the units are held for more than 3 years, then the returns earned on investments are treated as Long Term Capital Gains (LTCG) for the taxation purposes. And the gains are taxed at the rate of 20% after indexation benefit.

Liquid Fund Benefits

  • Low expense ratio: The expense ratio of liquid funds is relatively lower than that of other debt mutual funds. This ensures higher returns after deducting the costs. This is because most of these funds follow the strategy of holding the securities till maturity which saves the transaction costs that would have been incurred in aggressive buying & selling or switching between securities. Currently, the expense ratio for liquid funds are in the range of 0.14% to 0.97%.

Also Read: What is Expense Ratio in Mutual Funds?

  • No Lock-in period: Liquid funds do not have any lock-in period, however charges minimal exit load on units redeemed before 7 days.

Following are the exit load structure for different tenures:

1st Day - 0.0070%

2nd Day - 0.0065%

3rd Day - 0.0060%

4th Day - 0.0055%

5th Day - 0.0050%

6th Day - 0.0045%

7th Day & onwards - Nil

As there is no lock-in period, withdrawals can be made from the first day itself and thus is suitable for parking cash for meeting urgent needs.

  • Good returns: The returns from liquid funds are comparatively higher than the interests generated by a savings account. This makes liquid funds a good alternative to a bank savings account. Also, the feature of high liquidity adds to it.

The savings account generally offers 3-4% interest p.a whereas liquid funds could provide returns of 6-7% p.a.

  • Highly liquid: Liquid funds are highly liquid investments as these funds invest in highly liquid securities like T-bills, Commercial papers, Certificates of Deposits etc. with short maturities.

These funds allow the facility of quick withdrawals where usually the investor receives money in their bank account within 1 business day. Also, there are some funds which offer instant withdrawals of maximum Rs.50,000 or 90% of the investment amount daily, whichever is lower.

High liquidity makes it suitable for the investors to park their savings or a part of their emergency corpus which might be required on an urgent basis.

  • Low risks: As per the SEBI mandates, liquid funds have to make investments only in high-quality securities with high liquidity & shorter maturities of up to 91 days. This makes these funds a very low-risk investment as the chances of default on the underlying holdings are very low due to their high credit rating. However, these funds carry some interest rate risks but still, they are very less impacted compared to other funds because of their low maturities & durations.

More Information:

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Shariah Compliant Mutual Funds - Types, Who can Invest, Minimum Investment
Best Large Cap Mutual Funds to Invest in India
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