Money market mutual funds (MMF) invest in short-term debt instruments, cash, and cash equivalents that are rated high quality. It is for this reason that money market mutual funds are considered safe or investment with minimal to low risk. As these funds invest in high-quality instruments, they offer a predictable risk-free return rate.
1. How does Money Market Mutual Funds work?
Money market mutual funds (MMMF) are used to manage short-term cash needs. These funds are open-ended in the debt fund category and deal only in cash or cash equivalents. Money market securities have an average maturity of one-year; that is why these are termed as money market instruments.
The fund manager invests in high-quality liquid instruments such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit. Money market funds mainly target earning interest for the unitholders. The primary aim of money market funds is to minimise the fluctuation of the Net Asset Value (NAV) of the fund.
2. Types of Money Market Instruments
Following are the most popular money market instruments:
a. Certificate of Deposit (CD)
These are time deposits such as fixed deposits that are offered by scheduled commercial banks. The only difference between FD and CD is that investors are not allowed to withdraw CD until maturity.
b. Commercial Paper (CPs)
These are issued by companies and financial institutions which have a high credit rating. Commercial papers are also known as promissory notes, commercial papers are unsecured instruments, which are issued at the discounted rate and redeemed at face value.
c. Treasury Bills (T-bills)
T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. Treasury bills are considered one of the safest instruments as the government backs these. The rate of return, also known as the risk-free rate, is low on T-bills as compared to all other instruments.
d. Repurchase Agreements (Repos)
It is an agreement under which RBI lends money to commercial banks. It involves the sale and purchase of agreement at the same time.
3. Who should Invest in Money Market Mutual Funds?
A money market fund tries to offer the highest short-term income by maintaining a well-diversified portfolio of money market instruments. Investors having a short investment horizon of up to one year may invest in these funds.
Those individuals with low-risk appetite having their surplus cash parked in a savings bank account can invest in money market funds. These funds have the potential to offer higher returns than a regular savings bank account. The investors could be corporate as well as retail investors.
If you have a medium to long-term investment horizon, then money market fund won’t be an ideal option. Instead, you may go for dynamic bond funds or balanced funds, which are capable of providing relatively higher returns.
4. Things to Consider as an Investor
Money market funds face interest rate risk, credit risk, and reinvestment risk. In interest rate risk, the prices of the underlying asset increases as interest rates decline and decrease as interest rates rise. The fund manager may invest in risky securities which have a higher probability of default.
Money market funds have the potential to offer higher returns than a regular savings bank account. However, the returns are not guaranteed. The Net asset value (NAV) fluctuates with changes in the overall interest rate regime. A fall in interest rates may increase the prices of an underlying asset and deliver good returns.
Expense ratio refers to the fee charged by fund houses to manage your investment. SEBI has capped the expense ratio at 1.05%. As the assets under management (AUM) increases, the scheme tends to reduce the cost of operations.
d. Investment Horizon
Money market funds are suitable for very short-term to short-term investment horizons, i.e. three months to one year. For medium-term horizons, you may invest in other debt funds like dynamic bond funds.
e. Financial Goals
If you have to make EMI payments or invest extra cash while maintaining liquidity, then you can use money market funds. A small portion of your portfolio can be invested in these for diversification.
f. Tax on Gains
Investing in debt funds provides you with taxable capital gains. The tax rate depends on the holding period, i.e. for how long you stayed invested in the fund. You make a Short-term Capital Gain (STCG) when you stay invested for a period of fewer than three years.
Long-term Capital Gains (LTCG) are made when you stay invested for over three years. STCG from money market funds are added to your income and taxed according to your income slab. LTCG from money market funds is taxed at the flat rate of 20% after indexation.
5. How to Invest in Money Market Mutual Funds?
You can invest in money market funds with ClearTax in a hassle-free and paperless manner by following the below-mentioned steps:
Step 1: Register for an investment account by logging on to https://cleartax.in/save
Step 2: Enter the details requested
Step 3: Complete your KYC, the whole process can be completed within five minutes
Step 4: Choose and invest in the most suitable money market fund