Liquid Mutual Funds – What Are Liquid Funds | Risk, Returns & Benefits

Liquid mutual funds are debt funds that invest in fixed-income instruments with short maturity periods. The underlying debt and money-market instruments generally include certificates of deposit, treasury bills, commercial paper and more. As per the norms set by SEBI, these open-ended funds have to invest in debt instruments with maturity of less than 91 days.

Similar to any typical debt mutual fund, the returns of a liquid fund depend on the returns of underlying instruments. These returns are generally more stable than other debt funds. 

How Do Liquid Mutual Funds Work?

A liquid mutual fund’s primary function is to offer the benefits of high liquidity to investors while keeping the principal investment safe. The fund manager invests in debt instruments with a maximum maturity of up to 91 days with high credit quality. The low maturity helps in protecting the investment from interest rate changes. Also, the high quality of debt instruments helps in protecting the capital.

Though liquid funds don’t offer any guaranteed returns, their structure makes them one of the safest mutual funds. Liquid funds earn returns through the interest income and capital gains on their underlying debt instruments. 

Further, these funds do not have a lock-in period and you can redeem them even one day after investment. If you redeem the units of a Liquid MF within 7 days from purchase, as per SEBI’s new regulation you will have to pay a graded exit load. The exit load will be applicable as follows:

Who Should Invest in Liquid Mutual Funds?

Typically, liquid funds could be considered a suitable investment option for such investors who have substantial cash and are seeking short-term investment opportunities. Instead of keeping their money in a savings account you can earn slightly higher returns by investing in a liquid fund.

Furthermore, you can invest in liquid mutual funds if you want to create an emergency fund. The primary purpose of a liquid fund is capital protection along with steady returns at minimal risk. This will help you create a substantial corpus, which will come to the rescue during times of emergency.

Benefits of Investing in Liquid Mutual Funds

Here are a few advantages of liquid fund investments:

• Minimal Risk

A liquid fund is a low-risk investment option that offers stable returns and protection to the principal. The value of such funds generally remains stable in different interest rate cycles.

• Flexible Holding Period 

You can hold your investment in a liquid fund for as long as possible. However, investors may have to pay a minor exit load for redemption within 7 days. For most fund houses, such funds feature an extremely flexible holding period. This will allow you to enter and exit while earning returns more safely.

• Low Expense ratio

All mutual funds attract an annual fee, called expense ratio, for offering fund management services. Since liquid funds do not require a lot of active management like other funds, they are usually a low-cost investment option. Typically, most liquid fund schemes operate at an expense ratio of around 0.15%. 

• Swift and quick redemption

With liquid funds, you get the option to redeem your investment quickly. Most redemption requests are processed within a working day. Some fund houses even offer a facility of instant redemption. 

Returns of Liquid Mutual Funds

Typically, liquid funds earn through interest payments from their holdings. That said, a small proportion of liquid fund returns is generated through capital gains. Let us first understand the relation between the price of bonds and market interest rates to see how these funds generate capital gains.

When it comes to bonds, a fall in interest rates hikes the price of bonds and vice versa. The inverse relationship between bond prices and interest rates is substantial for long-term maturity periods. In simple terms, the longer the maturity period of a bond, the more it will get affected by market yields.

However, liquid funds do not invest in long-term securities. Thus, their market value is less dependent on the interest rate. This means that such funds do not feature substantial capital gains or losses. 

Types of Debt Instruments in a Liquid Fund’s Portfolio

To fully understand the meaning of liquid funds and start your investment journey, you need to know about the different types of debt instruments in which liquid funds can invest. Find details about them below:

• Certificates of Deposit

This works similarly to fixed deposits and is offered by scheduled commercial banks, Regional Rural banks, Small Finance Banks and All India Financial Institutions. Interest rates offered by CDs can be either fixed or floating.

• Commercial papers

Only financial institutions and large companies featuring a high credit rating can issue commercial papers. They are also called promissory notes and are issued at a discounted rate. You can redeem them at face value. The difference between the issue and redeem price is the return that an investor earns.

• Treasury bills

The Indian government issues treasury bills to generate money for a short term. They are presently issued in three tenures namely, 91 days, 182 days and 364 days. These are one of the safest investments, as they feature a sovereign guarantee. Furthermore, returns offered by T-bills are on the lower side.

Taxation of Liquid Mutual Funds

When you redeem units of a liquid fund, you may earn profits, called capital gains. The taxes applicable on capital gains on liquid funds are described below: 

• Short term capital gains (STCG)

If you redeem a liquid fund after holding it for less than three years, it is called short-term capital gains. In this case, you will have to pay tax as per the income tax slab you fall into.

• Long term capital gains (LTCG)

If you redeem a unit of a liquid fund after holding it for three years or more, the profits are called long term capital gains. LTCG from liquid funds are subject to taxes at a 20% rate. You will also receive the benefit of indexation, where the purchase price is hiked to match the inflation before calculating capital gains.

Things to Consider When Investing in Liquid Mutual Funds

Before you park your money in a liquid fund, consider looking through the following factors:

• Expense ratio

Fund houses tend to charge a percentage of a fund’s total assets as an expense ratio, which affects your returns. Liquid funds are mainly generic products, so most of them earn similar returns at any given time. So you should look for a fund with a low expense ratio to end up with relatively higher returns.

• Investment objectives

You must remember that liquid funds are not wealth-creating investments. Its major focus is on providing safety and liquidity for a modest return. Before choosing to invest in liquid funds, analyse whether you will be able to meet your investment objectives through this fund.

• Risk

Like all mutual fund products, returns from liquid MFs are steady but not guaranteed. The low tenure of the underlying instruments safeguards from the volatility of returns due to interest rate changes. Also, the fund value might drop if there is a downgrade of the credit rating of the underlying security. Hence, liquid funds are low-risk investments and not risk free.

Top 10 Liquid Mutual Funds Based on Returns

Now that we have learnt about liquid funds, let us check the best liquid funds based on their past performance:

Final Word

Liquid mutual funds are a popular debt investment instrument, offering stable returns at low risks. You can consider opting for this route if you have enough savings to park. However, remember to conduct proper market research before making any investment decision.

FAQs about Liquid Mutual Funds