Liquid Funds 101 – Everything You Need To Know About Short Term Debt Funds

Liquid Funds are debt mutual funds that invest into debt securities with very short maturities. The residual maturities if bonds held by liquid funds cannot exceed 90 days, as per the rules defined by the regulator. In fact, most liquid mutual funds hold securities that are due to mature in the next 30 days or so. Bonds maturing within two months need not be ‘marked to market’ – only their interest component needs to be factored in while calculating NAV’s (net asset values).  Hence, the NAVs of Liquid Funds remain relatively steady compared to other debt funds.

Are Liquid Funds Risk Free?

Liquid funds are very low risk, but not risk free. There’s a chance that bonds held by liquid funds can default, if the companies that issue them are in severe financial distress. Owing to the very short maturities of the bonds held by liquid funds, his remains a remote possibility - but the risk still exists on paper. When a bond held by a liquid fund defaults and is subsequently downgraded to a “D” rating by any leading ratings agency, the fund needs to write off its value entirely. This results in a hit on the fund’s NAV. A case in point was the relatively recent Taurus Mutual Fund fiasco, wherein the fund had to write off close to 10% of its holdings in BILT, after the latter defaulted and was downgraded. So, liquid funds are very low risk, but not risk free. It’s best to stick with liquid funds of large and renowned AMC’s, which employ more robust research teams.

Do Liquid Funds Provide Guaranteed Returns?

Contrary to popular belief, Liquid Funds do not provide guaranteed returns. However, they do provide relatively steady returns compared to all other classes of Mutual Funds, owing to the nature of their portfolios. Liquid funds typically provide returns that are similar to ‘call money’ rates, meaning that they can be expected to provide annualized returns in the range of 6% to 7% in the immediately foreseeable future.

How are Liquid Funds used in STP’s (Systematic Transfer Plans)?

Their low volatility, steady returns and zero exit costs make liquid funds an ideal choice as a deployment vehicle for STP’s (Systematic Transfer Plans) into equity funds. Instead of investing a lump sum into an equity mutual fund, you could choose to park your money into a liquid fund, and initiate an STP into an equity fund from it. Over time, your liquid fund balance would be transferred to the equity fund. In this way, you’ll be protected from the risk of investing your entire money at an interim market peak. You’ll benefit from corrections as you’ll be making a staggered entry into the equity fund. At the same time, your idle balance will earn better returns than your savings bank account.

How are Liquid Fund Returns Taxed?

Profits earned on your liquid fund units (at the time of redeeming or switching them) are taxed per your income tax bracket if the units are redeemed within three years - a highly likely scenario, given that liquid funds are meant for short term investments). In the unlikely scenario that you hold on to your liquid fund units for more than 3 years, the profits will be indexed for inflation and taxed at a flat rate of 20%. If you fall into the highest tax bracket, you could go for the dividend reinvestment option to marginally reduce your tax outgo.

High Liquidity

As their name would suggest, liquid funds are highly liquid in nature. If you place your request for a redemption before 3 pm today, you’ll get your money in your account the next morning. However, SEBI has recently mandated that AMC’s should allow instant redemptions of up to Rs. 50,000 from Liquid Funds. Many AMC’s have already implemented this. Your Financial Advisor can help you clarify which funds currently offer this facility, and which ones do not.