What Are Liquid Funds? [Learn Everything!]

Life is full of surprises. Unexpected financial needs can arise anytime. Having your money invested can trouble you accessing it quickly or may lead to penalties. Hence, you need to be prepared with a smart financial strategy that includes liquid funds.

“Liquid funds” – one of the popular investment options that offer their investors convenient access to their funds quickly without worrying about penalties or restrictions. In this comprehensive guide, have all your potential doubts about liquid funds answered.

Liquid Funds: Meaning & Explanation

Liquid funds are debt-oriented mutual funds that invest in debt securities with a maturity period of up to 91 days.

Fund managers routinely reinvest redeemed capital into fresh securities as soon as certain existing securities reach their maturity.

This operational feature ensures a continuous cash flow cycle, featuring these funds with an exceptional degree of liquidity.

Where Do Liquid Funds Invest

The specific allocation of investments may vary among different liquid funds. Let’s have a look at common debt securities liquid funds invest in.

1. Treasury Bills

These are short-term government securities issued by the central government. They have a maturity period of up to one year and are considered to have minimal credit risk.

2. Certificates of Deposits

Certificates of deposits (CDs) are a type of time deposit with maturity ranging from a few months to several years. CDs are offered by banks & Financial institutions.

3. Commercial Papers

Commercial papers are issued by well-rated corporates, financial institutions etc to bridge temporary cash flow gaps or meet other short-term obligations. They come with maturity periods ranging from 7 days to 364 days & are issued at a discount rate.

4. Interbank Call Money

It refers to short-term borrowing and lending between banks. Banks with excess funds lend to banks in need of funds for a specified period, typically ranging from overnight to a few days.

5. Government Securities

Government Securities are considered one of the safest investments available in the market due to the creditworthiness and stability of the government as the issuer. Government issues these securities to finance its fiscal needs and manage its borrowing requirements.

Did you know there is a distinct type of mutual fund which exclusively invest only in government securities? They are called Gilt Funds and are considered very low-risk or sometimes "no risk" funds due to the unlying securities backed by the government.

Liquid Funds Average Returns

Investors allocate their hard-earned money to earn some extra income. Various investment vehicles come with different levels of interest rates, often correlating with the level of safety they provide.

For instance, liquid funds are considered safer investments providing the protection of capital. They typically generate an average interest return between 4% to 8% annually which is a better return compared to what savings accounts may offer.

Advantages & Disadvantages

The following are the chief advantages & Disadvantages of liquid funds.

Tax Treatment on Liquid Funds

Liquid funds are a type of debt mutual fund and therefore they are taxed similarly to other debt funds. Taxation for debt funds involves two categories; 1. STCGs (funds sold before three years), 2. LTCGs (Fund sold after 3 years of investment).

Under the recent changes in taxation rules, both STCG and LTCG from debt funds are now subject to tax according to the applicable Income Tax slab rate.

Liquid Funds Vs FDs

While liquid funds and Fixed Deposits (FDs) have distinct features, it’s important to note that they may not be direct substitutes for each other. However, considering the following points can help you determine which option best suits your needs.

Further Reading: A Guide to Short-Term Fixed Deposits

1. Nature of Investment: Liquid funds are highly liquid means you can access your money quickly. FDs are not as liquid as liquid funds and premature withdrawals may incur penalties or reduced returns.
2. Returns: However liquid funds offer better returns compared to savings accounts, The returns on liquid funds are market-driven and fluctuate based on prevailing interest rates. FDs promise a fixed return that is predetermined at the time of investment.
3. Risk: Liquid funds carry some degree of risk due to the fluctuations in interest rates and credit risk associated with the underlying securities. FDs are considered relatively safer as they are backed by the bank’s or institution’s guarantee.
4. Taxation: In recent years, Liquid funds and FDs were taxed differently. Currently, they both are subject to tax according to the income tax slab rates.
5. Investment Horizon: Liquid funds are suitable for investors with a short-term investment horizon and who want easy access to their funds. FDs are fit for investors with investment horizons ranging from a few months to several years.
6. Diversification: Liquid funds offer diversification by investing in a range of debt instruments, reducing the risk associated with investing in a single security. FDs do not offer diversification since the investment is concentrated in a single bank or institution.

Who Should Invest In Liquid Funds

Liquid funds are best suitable for investors with low-risk appetites and who seek high liquidity. Types of investors interested in liquid funds may include:

A. Individuals with idle cash: If you have some surplus amount that you don’t need immediately, you can invest in liquid funds to get better interest compared to leaving your money in a savings account.

B. Purpose of emergency fund: Having the feature of high liquidity and steady income, liquid funds can be a good place to park money for emergency funds.

C. Corporate entities: companies maintain short-term cash reserves for urgent financial needs. Liquid funds can be a good alternative to keeping excess cash idle in a bank account.

D. Conservative investors: Liquid funds are good investment opportunities for conservative investors with low-risk tolerance or sensitivity to market fluctuations.

How to Invest in Liquid Funds

Investing in liquid funds is easy. You are only a few steps away to start investing in liquid funds. Here are the steps:

1. Choose a mutual fund company
2. Select a suitable liquid fund
3. Set up an investment account with the company or any online platform that offers the fund you choose.
4. Complete KYC and necessary documentation
5. Decide the amount and mode of investment
6. Start investing in liquid funds

Helpful Reading: Guide to Choose Best Mutual Fund

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