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Liquid funds are a class of debt funds that predominantly invest in high-quality fixed instruments that mature within 91 days. The asset allocation of liquid funds is made towards certificates of deposit, treasury bills, commercial papers, and so on.
Liquid funds are debt funds that invest in fixed-income securities such as certificates of deposit, treasury bills, commercial papers, and other debt securities that mature within 91 days. Liquid funds do not come with a lock-in period. The redemption requests of liquid funds are processed within 24 hours on business days.
The risk levels of liquid funds are on the lower side. Liquid funds are considered to least risky among all classes of debt funds as they mostly invest in high-quality fixed-income securities that mature soon. Therefore, these funds are suitable for risk-averse investors.
The table below shows the top-performing liquid funds based on the past 3 and 5-year returns:
Who Should Invest in Liquid Funds?
The returns offered by liquid funds are much higher than that of a regular savings bank account. Therefore, if you have any surplus funds, then you may consider parking them in liquid funds and earn better returns. As the fund mostly invests in high-quality securities, the risk-averse investors may also consider investing in liquid funds.
Liquid funds are the least risky among all classes of debt funds. The NAV doesn’t fluctuate too frequently as the underlying assets have maturity period in the range of 60 days to 91 days. This prevents the NAV of liquid funds from getting impacted by the underlying asset price fluctuations. However, there might be a chance of a sudden drop in NAV. This can happen due to an abrupt decline in the credit rating of the underlying security. In simple words, liquid funds are not entirely risk-free, but safer than most other classes of mutual funds.
Historically, liquid funds have provided returns in the range of 7% to 9%, which is way higher than the mere 3.5% interest that a regular savings bank account offers. Even though the returns on liquid funds are not guaranteed, more often than not, they have delivered positive returns on redemption.
Liquid funds, like all mutual funds, levy a fee to manage investments, called ‘expense ratio’. The Securities and Exchange Board of India (SEBI) has mandated the expense ratio to be under 2.25%. Considering the hold till maturity strategy of the fund manager, liquid funds maintain a lower expense ratio to offer comparatively higher returns over a short period.
Liquid funds are exclusively for investing the surplus cash over a short duration, say up to three months. Such a short horizon helps to realise the full potential of the underlying securities. In case you have a longer investment horizon of up to one year, then you may consider investing in ultra-short-term funds to get relatively higher returns.
If you want to create an emergency fund, then liquid funds can prove to be very useful. Since there is no lock-in period, it helps you pull out your money quickly in case of emergencies.
As the assets that the liquid funds invest in mature within 91 days, these funds do not witness high volatility. This translates to the net asset value (NAV) of liquid funds remaining relatively stabler as compared to other classes of debt funds. Therefore, this kind of mutual funds is said to be suitable for risk-averse investors.
Nevertheless, like any other investment option, even the liquid funds are not entirely risk-free. If there is any change in the credit ratings of the underlying securities, then it may lead to a change in the NAV of the fund. Therefore, even liquid funds are not entirely risk-free. However, the short maturity period of the underlying securities mitigates the associated risks to a great extent.
The dividends offered by liquid funds, if any, will be added to your overall income and taxed as per the income tax slab you fall under. The rules of taxation of debt funds apply to the capital gains provided by liquid funds.
You make short-term capital gains on redeeming your investment within three years from the date of allotment. These gains are added to your income and taxed as per the income tax slab you fall under. You make long-term capital gains on selling your debt fund units after three years. These gains are taxed at a rate of 20% after indexation.
The following are the most significant advantages of investing in income funds:
The liquid funds are not actively managed like most other debt funds. Therefore, the expense ratio of liquid funds is on the lower side, resulting in higher take-home returns.
As mentioned earlier, the risk possessed by liquid funds is on the lower side as the underlying securities mature within 91 days. This mitigates the risk of volatility.
Liquid funds, as the name suggests, are open-ended mutual funds. Therefore, you can redeem your units at any time. However, a small charge in the form of an exit load is levied on exiting within seven days from the date of allotment.
The redemption requests are generally processed within a working day. Some liquid funds facilitate instant redemption.