Liquid funds can be considered as baby steps to enter the world of mutual funds. As the name suggests, liquid funds mean funds in which the amount invested can also be redeemed with ease.
What are these funds?
A liquid fund is a very low risk debt mutual fund scheme. Parking your surplus money here for a very short time-frame in liquid funds may seem like a good idea as they offer relatively better returns than bank deposits on a post-tax basis for investors in the 30 per cent tax bracket and with high liquidity, with some mutual funds offering instant receipt of money from the mutual fund as well.
Returns and Risks
Liquid funds invest only in debt securities with a residual maturity of less than or equal to 91 days. The lower maturity mitigates interest rate risk, along with credit risk (default risk). Liquid funds invest in fixed maturity interest-paying instruments, such as call money, CBLO, Repo, Reverse Repo, commercial papers (CP), non-convertible debentures (NCD), certificates of deposit (CD) and Treasury Bills (TBs).
As per SEBI regulations, non-traded securities that have a residual maturity of up to 60 days do not have to be marked to market, with certain exceptions to this rule. For listed securities (such as TBs and NCDs), mark-to-market valuation applies irrespective of the residual maturity.
Hence, liquid fund’s NAV movement is virtually linear; a steady line going up which has virtually no market risk.
Does this mean your liquid funds are risk-free? Virutally yes – Absolutely No!
The liquid fund can invest in scrips that mature up to 91 days. Therefore, if it invests in scrips that mature between 60 and 91 days, it needs to mark-to-market the same, depending on its credit rating. To keep things simple, if such an underlying company defaults on its interest and/or principal repayment, the scrip’s credit rating drops and so does its market price. If your liquid fund has invested in such a security, its NAV falls too. Typically, however, most debt funds invest in scrips that mature around 15 to 20 days to curtail their risk.
You can reasonably expect your liquid funds to return around ~6-7% returns in a year.
Benefits of liquid funds
- No lock-in period.
- Withdrawals from liquid funds are processed within 24 hours on business days. The cut-off time on withdrawal is generally 2 p.m. on business days. It means if you place a redemption request by 2 p.m. on a business day, then the funds will be credited to your bank account on the next business day by 10 a.m.
- Liquid funds have the lowest interest rate risk among debt funds as they primarily invest in fixed income securities with short maturity.
- Liquid funds have no entry load and exit loads.
Just like any other mutual fund, liquid funds also come with two options: growth and dividend. Under the growth plan, units redeemed before 36 months attract short-term capital gains tax and the returns are taxed at the slab rates. Units that are redeemed after 36 months attract long-term capital gains tax at the rate of 20 per cent, with indexation benefits.
On the other hand, under a dividend plan, while dividends declared by funds are not taxable in the hands of the individual, all non-equity funds attract a dividend distribution tax (DDT) of 28.84 per cent, which is deducted and then given to the investor.
Thus, the tax treatment plays an important role in deciding the investment option.
Is the dividend option for you?
Investors can keep their short-term money in their savings account itself ideally if they are saving less than Rs 2.5 lakh a year. Savings accounts score better from a tax perspective; interest up to ₹10,000 is exempt under Section 80TTA of the Income Tax Act.
If we assume 7 per cent returns on liquid funds, the post-tax returns work out to 6.3 per cent, 5.6 per cent and 4.8 per cent, respectively, for individuals in the 10, 20 and 30 per cent tax bracket. This is higher than the 3-4 per cent that most banks offer. A few banks offer a higher 5-6 per cent interest on high-value deposits.
However, if you hold over ₹2.5 lakh in the savings accounts, liquid funds would still offer better returns.
Investors in the 10-20 per cent bracket can opt for the growth option rather than the dividend option since the effective tax rate will be lower under the growth option.
For investors in the 30 per cent tax bracket, the dividend option may be a better route as any redemption before 36 months will attract tax at 30.9 per cent.
In case the investor’s income exceeds ₹1 crore, remember that short-term capital gains tax will be higher at 35.53 per cent due to the surcharge of 15 per cent
Low-risk investors with a time horizon of more than 36 months can invest in growth option of liquid funds. The gains on the units redeemed after 36 months attract long-term capital gains tax at 20 per cent with indexation. Under this, the cost of investment and redemption amount are adjusted with the inflation index and then taxed. In this case, the tax will be almost nil or negative (which can be carried forward against other long-term capital gains subject to conditions). This indexation benefit is not available on bank FDs.