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Best Liquid Funds To Invest

There are many alternatives for investors who want to invest in low risk mutual funds. Among them is the debt fund, which inthese kinds of funds. Choose those companies that are large and have a good reputation in the mavests in fixed income instruments like government securities, commercial paper, and debentures. If you want steady and reliable returns without much risk, debt funds are your investment of choice.

One of the choices available for investors is the liquid fund. If you come into a large amount of cash suddenly, where can you put them for a short time until you find a profitable investment option? For example, if you are thinking about what equities to buy or waiting for a great property deal? In that case, the best place to put your money would be liquid funds. Top liquid funds don’t carry much risk and offer much better returns than, say, bank savings deposits. You can invest in these funds for a day, a week, or as long as you choose.

So what then are liquid funds? Before we get to that, we must understand the concept of a liquid asset. A liquid asset is one that has many potential buyers and sellers so that it can be bought and sold quickly at full market price. Liquid assets include government securities and money market instruments. Liquid funds, thus, are those that can be bought and redeemed quickly.

Here are some of the instruments liquid funds invest in:

  • Treasury bills: Treasury bills or T-bills are short-term instruments used by the government to raise funds from the financial markets. T-bills can have maturity periods of 91 days, 182 days or 364 days. Generally, these funds invest in 91-day T-bills. T-bills are zero-coupon bills, which means they carry no interest and are issued at a discount. They are then redeemed at face value on maturity. For example, a 91-day bill may be issued at Rs 98 and redeemed at Rs 100.

  • Certificates of deposit: A certificate of deposit is a money market instrument issued by specified banks and financial institutions to individuals, companies and other entities. It is basically like a fixed deposit with a bank – you deposit the amount, and the bank issues you a certificate of deposit. Generally, this is done in dematerialised form. Certificates of deposit have fixed maturities, ranging from a few months to several years.

  • Commercial paper: Commercial paper is an unsecured money market instrument issued in the form of a promissory note. It is a short-term paper and can be issued by companies, primary dealers and financial institutions. Maturity periods range from seven days to a year. They are actively traded in the Over The Counter (OTC) market.

Liquid funds are tailor-made for investors with a very short-term perspective. They invest in fixed income instruments with very short residual maturities of up to 91 days, like treasury bills, certificates of deposit and commercial paper. The focus of these funds is basically capital protection, rather than ensuring high returns. So fund managers of these funds tend to err on the side of caution and invest only in those instruments that have a high credit rating. Mutual fund companies try to keep costs to a minimum so that investors don’t have to pay high expense ratios and reduce their returns.

Among all the different kinds of debt funds, liquid funds involve the least amount of risk because they mainly invest in government paper and corporate instruments with high credit rating.

A low-risk option

Like all other debt funds, liquid funds are exposed to interest risk. When interest rates go up, yields on fixed income instruments go down and your net asset value (NAV) will fall. When interest rates fall, yields will go up, as will your NAV.

However, these funds tend to keep these fluctuations to a minimum. This is because according to the Securities & Exchange Board of India (SEBI) rules, securities with a maturity of less than 60 days do not have to be marked to market. Besides, these funds hold the securities until maturity and do not buy and sell them before that. Hence, they are relatively immune from interest rate risk. The returns on liquid mutual funds will be fairly constant, and your investment will keep increasing in value until redemption.

So does that mean that these funds are totally risk-free? No, not entirely. Since these funds invest in fixed income instruments of various entities, there is a risk of default. If any one company defaults, it will drag the NAV down. But you should remember that the risk is very low since fund managers invest only in paper with a high credit rating. Anyway, much of it is government debt, so there is almost no chance of default.

Liquid mutual funds are open-ended, which means that investors can buy them whenever they choose and redeem them at any point. There are also growth and dividend options. So if you need cash while you wait, you can choose the dividend option.

You can park your surplus cash in liquid funds and use a systematic transfer plan (STP) to transfer money in a systematic way to another debt fund or even an equity fund. The funds can be transferred on a daily, weekly, monthly or quarterly basis. You can do the transfer from one fund to another, either of the same asset management company or a different one.

For investors looking at a slightly longer time horizon, say six to nine months, there are ultra short-term debt funds. These invest in longer maturity periods of say, up to three months, and are not as liquid. Since the maturities are of longer periods, the risk of NAV fluctuations is correspondingly higher.

What are the advantages of liquid funds?

  • High liquidity: The most obvious benefit of investing in these funds is, well, the liquidity. These funds are open ended, have no exit loads and can be redeemed in a day. Some even offer instant redemption, so the cash could be in your bank account in a matter of minutes! So it’s ideal for parking emergency or contingency funds in your possession. Market regulator Sebi has capped that amount that can be instantly redeemed at Rs 50,000 or 90 percent of portfolio value, whichever is lower.

  • Good returns: They offer better returns than bank savings deposits, so your idle cash will earn more money.

  • Low risk: The fund manager’s focus is on capital protection, so these funds will invest only in those instruments that have a good credit rating. So the risks are low. In any case, most of the fund’s investments will be in government paper, which carries minimal risk.

  • Flexible: These funds are very flexible and offer growth and dividend plans. You can get dividends on a daily, weekly or monthly basis.

  • Protection against inflation: If you want protection against inflation, these funds are your best bet since the Reserve Bank of India raises interest rates during inflationary times, and you will benefit from that. The shorter tenure of the fund’s investments and the fact that they are mostly held until maturity will ensure that your existing investment is protected from falling yields.

  • Low fees: The costs of these funds are generally low. Mutual funds keep expense ratios low to attract investors.

  • Access to more instruments: These funds invest in fixed income instruments like government bonds which are unavailable to the retail investor. So you will be able to take advantage of instruments that offer reasonable returns and involve low risk.

  • Diversification: If you want your portfolio to have a mix of short and long term instruments, you could consider this type of fund.

How to invest in top liquid funds

All liquid mutual funds are not alike. Here’s how you find the right one-

  • Composition of the fund: Generally fund managers select fixed income instruments with high credit ratings, but it won’t hurt to check what’s in the portfolio of the funds you are purchasing. The top liquid funds will have a high proportion of government securities and treasury bills; they carry less risk.

  • Compare returns: Check the returns of funds for the past few years. Many websites offer comparisons of various funds, and you can check the kind of returns each offers and find the best funds. However, you must remember that these funds invest in similar kinds of debt, and of an almost identical duration, so returns won’t differ all that much. Higher returns could mean that the funds are investing in debt that involves more risk. In that case, you might want to consider whether you want to invest in riskier funds.

  • Fund house: Make sure you select the right fund house with good expertise in mutual funds. Look for those that have shown consistent returns, especially with these kinds of funds. Choose those companies that are large and have a good reputation in the market. Mutual fund distributors like Angel BEE can help you find top liquid funds for you.

  • Maturity of investments: Liquid funds should make investments in instruments with an average maturity of 30-90 days. Remember, instruments that have longer maturities will have to be marked to market, and this exposes you to interest rate risk. So if interest rates rise, yields and thus NAVs will drop.

  • Expense ratio: Look closely at expense ratios as even a small difference will affect your returns. However, these funds tend to have low expense ratios because the returns are on the lower side too. Besides, these kinds of funds does not require active management on the part of fund managers.

  • Credit rating: It may be helpful to look at the credit rating of the paper that these funds invest in. Generally, these funds invest in highly rated paper. So make sure that all the fund’s investments have an A1 or AAA rating.

Taxation of liquid funds

Debt funds that are held for under three years are subject to short term capital gains tax. Paying tax on liquid funds is unavoidable as they are held for much shorter periods than three years. The gains from the funds will be added to your taxable income and you will have to pay tax according to the tax slab you’re in. You will have to pay the most if you are in the highest tax bracket.

There may be a way of reducing your tax liability to some extent. There are two options when it comes to these funds – growth and dividend. In the growth option, dividends are reinvested in the fund and you get returns after redemption. In the dividend option, any dividends declared will be sent to you. Dividends are not taxable in the hands of the investor. However, there is a dividend distribution tax, which is charged to the fund, which it then passes on to the investor.

Another factor that you need to take into account while considering liquid funds is that interest income up to Rs 10,000 earned in a financial year is exempt from tax under Section 80TTA. So make sure you get the full benefit by keeping your cash in a savings account until your interest income reaches Rs 10,000 a year.

But even with these disadvantages, these funds can offer better returns than bank savings deposits. In the past few years, these kinds of funds have made returns of 7-8 percent compared to savings bank interest rates of 3-4 percent. If you are in the 20 percent income tax bracket, a 7 percent return would translate into 5.6 percent post tax return. If you are in the 30 percent bracket, you will suntil earn a post-tax return of 4.9 percent, which will suntil be higher than what a savings account offers.

Of course, if you remain invested in these funds for over three years, you will get the benefit of indexation. Long term capital gains tax on debt funds held for over three years attract a tax rate of 20 percent with indexation, or 10 percent without indexation. But if you want to invest over a long term horizon, you would be better off with income funds or gilt funds.

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