Liquid Funds

Liquid Mutual funds are a category of debt mutual funds that invest in debt instruments that have residual maturities of up to 91 days.

A few examples of the instruments liquid funds invest in are T-bills (Treasury Bills), CPs (Commercial Papers), CDs (Certificates of Deposit) and CBLOs (Collateralised Lending and Borrowing Obligations). 

While each of these instruments are different from each other, their most important aspects - risk and returns - are quite similar.

Liquid funds are considered to be quite low risk and meant for short-term investments ranging from a few days to a few months. In fact, the AMFI website says that liquid mutual funds are a good alternative to bank accounts as they have the potential to generate higher post-tax returns.

While you should identify your risk profile and plan your financial goals before investing in liquid funds, here are some situations where liquid funds may fit:

Alternative to Bank Accounts

Liquid funds are very low risk instruments and a good alternative to savings bank accounts. 

As of Nov 2023, yields on liquid funds are around 7%. On the other hand, interest rates offered by banks are in the 2.5-4.5% range. So, liquid funds are likely to grow your cash faster than savings bank accounts.

Source: Value research, SBI Bank, HDFC Bank websites

However, yields keep changing based on various factors and may not always be higher than savings account interest rates.

Note: While the liquid funds are good alternatives to savings bank accounts, they are not insured like bank deposits. Bank deposits of up to Rs. 5 lakh per bank per account are insured by a government agency.

Source Funds for STPs (Systematic Transfer Plans)

STPs or Systematic Transfer Plans involve transferring money from one mutual fund scheme to another. Like an SIP, it is automated and fixed amounts are transferred at a fixed frequency.

In every STP, there’s a source fund (the fund where the money is) and a target fund (the fund where the money should go). A typical STP involves transferring money from a stable, low-risk fund (like debt fund) to a volatile, high-risk fund (like equity funds).

STPs are generally used to deploy large amounts in mutual funds. The large amount is parked in the source fund and systematically transferred to the target fund. This helps in spreading the investments in the target fund over time, similar to SIPs, and averaging the purchase cost.

Liquid funds make for a good option for source funds in STPs because of their low volatility and stable returns.

Portfolio Diversification

It is well known that diversification of investment portfolios across asset classes reduces the risk of investing. And a commonly observed problem in investment portfolios is that they are heavy on equity and low on debt.

Since liquid funds are very short-term debt instruments, they can be considered for diversification of specific short and medium investment portfolios.

Many investors wonder if liquid funds are better than FDs or fixed deposits. While the answer is different for everyone, here’s a quick comparison between the two:

Liquid funds, like all mutual funds, are well-regulated. Further, the SEBI has defined risk management guidelines to safeguard the money of investors like you.

Here are some of the risk management guidelines liquid funds are required to follow:

Minimum 20% Allocation to Government Securities

Liquid funds are required to invest at least 20% of their assets in Government Securities like T-Bills (Treasury Bills).

Government Securities are among the lowest risk instruments. By allocating significant assets to them, the overall risk associated with liquid funds is also lowered.

Graded Exit Load

Companies park their surplus cash in liquid funds to generate returns. However, they need cash regularly and in large amounts resulting in frequent withdrawals.

These frequent investments and exits affect the other investors who stay invested. This is because the fund manager may have to sell securities prematurely at not-so-good prices to honor the redemption request from large liquid fund investors.

To safeguard the retail investors from this, SEBI introduced graded exit load in liquid funds in 2021. The introduction of exit load was aimed towards minimising the instances of large redemption within a few days of investing. Prior to this, liquid funds had nil exit load.

SEBI has made it compulsory for mutual fund companies to charge an exit load if investors pull out their money within 7 days of investing. This is aimed at discouraging quick buying and selling of funds, which can adversely affect the other investors.

Restrictions on Sector Exposure

Liquid funds can invest only up to 20% in one specific industry’s debt instruments.

This guideline ensures that the portfolio is diversified and not at a high risk from a collapse in one sector.

Short Term Capital Gains (STCG) Tax on Liquid Funds

For investments made before 1st April, 2023: All gains registered within 3 years from the investment are taxed at your marginal income tax rate

For investments made after 1st April, 2023: Same as above

Long Term Capital Gains (LTCG) Tax on Liquid Funds

For investments made before 1st April, 2023: All gains registered after 3 years from investment are taxed at a 20% flat tax rate with the benefit of indexation

For investments made after 1st April, 2023: From 1st April onwards, all debt capital gains lose LTCG and indexation benefits and will be taxed like STCG - at your marginal income tax rate

Dividend Distribution Tax on Liquid Funds

Liquid funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option.

Dividends from liquid funds are taxed at your marginal income tax rate.

TDS (Tax Deducted at Source) at 10% is applicable on dividends received in excess of Rs 5,000 per AMC per financial year.

In short: For liquid funds investments made after 1st April, 2023 all the dividends and capital gains from liquid funds are taxed at your marginal income tax rate.