For most of the investors, saving bank account becomes the preferred destination to park their surplus funds. Even when they need to build a contingency fund, they cannot think of better havens.
The reason for such a decision might be lack of awareness or time crunch. However, leaving your short-term funds in a saving bank account is the least efficient way from an investment standpoint.
Now you may ask “Is there a better a better way to deal with surplus cash?”
Of course yes! Invest your short-term funds in ‘Liquid Funds’.
Liquid funds have evolved as an ideal haven for short-term investors. They are a convenient means to earn better returns as compared to a savings bank account.
Let’s have an in-depth look at liquid funds.
Liquid Fund is a type of debt mutual funds. These are open-ended schemes which have a short-term investment horizon. These open-ended schemes have a short-term investment horizon and invest primarily in money market instruments like the certificate of deposit, treasury bills, and commercial paper of up to 91 days.
The investment objective of liquid funds is to preserve capital and provide income via creating ample liquidity. For this, the fund manager invests only in investment-grade debt instruments.
You can choose to invest for a few days or months, depending on your financial needs. The fund returns will be based on the prevailing market rates. The best part is that there is no exit load applicable to liquid funds. The schemes are also available in variants like Daily/Weekly/Monthly Dividend and Growth option.
Not only will you be able to earn steady returns over short time intervals, but you can also choose to redeem a part or the entire amount of investment within 24 hours.
From a returns perspective, saving accounts offer a low rate of return. Soon after demonetisation, banks have tremendously reduced the interest rates on savings accounts.
Banks are now offering an interest rate of as low as 4% on an account balance up to Rs 1 lakh. For those who maintain balances above Rs 1 lakh are offered differential interest rates. However, for small investors, it is challenging to avail such an opportunity.
For an individual falling in the highest tax bracket, the post-tax returns on savings account would be around 2.8%. Such a return is highly inadequate to counter inflation. Therefore, to make the best use of short-term funds, liquid funds are a better alternative.
On average, returns generated by liquid funds are in the range of 7% to 9%. Assuming that the tax rate is 30%, the post-tax return would be around 5% to 6%, which is relatively higher than the savings account.
You may consider a savings account as an alternative to generating a risk-free return. Moreover, you are assured of the interest being credited to your account. Most banks generally do not revise the interest rates on a savings account frequently.
However, liquid funds are not entirely risk-free. You may perceive them as low risk-low returns instrument. As they invest primarily in debt instruments, they might be subject to interest rate risk and credit risk.
A change in the prevailing interest rates may cause a difference in the price of the debt instruments. This, in turn, may cause the NAV of the liquid fund to fluctuate. Since liquid funds invest mainly in short-term debt securities, you may not find sharp fluctuations in NAV of the fund.
When discussing credit risk, it refers to the likelihood of default in the payment of interest and principal by the issuer of the debt instrument. Liquid funds ensure that your money is invested only in superior creditworthy instruments.
In this way, the fund manager can reduce credit risk by holding a well-diversified portfolio of securities.