Liquid Funds - All you need to know

As the Covid-19 pandemic makes people realize the importance of an emergency fund, it's time to look at Liquid Funds.

Liquid Funds are debt mutual funds which invest in money-market and debt instruments with a maturity period of 91 days. Given their high liquidity and low risk, they are a great option for a short-term investment for idle money or for an emergency fund. Let's look at each aspect of this product.

Liquidity

As the name suggests, it is designed to offer great liquidity. Although not at par with Savings Bank (which is as good as cash if you have a debit card with you), the liquidity offered by Liquid Funds is good enough for most emergencies. While some liquid funds offer instant online redemption, almost all funds offer redemption within 24 hours or one working day.

That a liquid fund doesn't offer the ease of redemption like an SB is also an advantage, particularly for those who lack the discipline in their expenditure. To illustrate, would you like to keep Rs. 2 lakhs entirely in an SB account or keep some portion in a Liquid Fund away from debit card theft or impulsive spending.

Most importantly, Liquid Funds give you the option of partial withdrawal whereas in FDs the entire amount is redeemed, whether it is premature withdrawal or completion of tenure.

Returns and taxation

With a return of 6% to 6.5% for most, Liquid Funds perform significantly better than Savings Bank (SB) accounts and slightly better than Fixed Deposits (FD). While this is true for most, some private banks and Small Finance Banks offer as much as 7% return for Savings Bank accounts. Likewise, some NBFCs also offer FDs which offer 1-2% more than most banks.

While interest from SBs and FDs is taxable at the tax slab irrespective of the tenure or time period, income from liquid funds held for three years or longer is treated as Long-Term Capital Gains which is taxed at 20% with indexation. In other words, a liquid fund investment of three years or more attracts less tax compared to FDs and SBs.

While most FDs charge a certain fee or penalty for premature withdrawal or "breaking" an FD, there is no such fee for liquid funds as long as it is held for longer than 7 days.

Risk and Volatility

Among Debt Mutual Funds, Liquid Funds have the least risk and volatility as it invests in short-term, mostly AAA-rated or safe instruments such as government securities. However, even if low, these products do carry some credit risk as a default or downgrade of the instruments is possible. Due to the downgrade of debt papers issued by IL&FS, many investors saw some loss to their Liquid Funds.

The biggest advantage of SBs and FDs is that they offer a fixed income. Budget 2020 also increased the deposit cover available to FDs and SBs to Rs. 5 lakhs, in case the bank fails. 

So what should one choose? And how?

While an FD offers reasonable returns, it comes with a lock-in that makes it unsuitable for investors who may need the cash anytime. 

Let us consider the current situation in which banks are reducing interest rates and the ongoing Covid-19 lockdown is discouraging investments in the markets. Liquid Fund is ideal for investors who want to park their money for a few months or use it as their emergency fund. A combination of an FD with a Liquid Fund will be useful in such a situation.

While choosing a Liquid Fund, one must evaluate it on -

Ease of deposit and redemption: Does the AMC allow instant online redemption? Or does it require a full working day to credit the amount to your account? Likewise, how easy is to deposit the money?

Credit Quality - The best Liquid Funds invest mostly in government securities and have a large enough AUM (Assets Under Management) to tide over any problems even if too many investors withdraw money.

Returns and expense ratio - Last, and the least important, you should pay attention to returns if there is no major difference among the Liquid Funds for other criteria. This is the least important because an extra return of around 0.5% to 1% isn't worth any risk to your capital or liquidity.