One of the many options for mutual fund investors is the debt fund. A debt fund invests in fixed income instruments like government securities, commercial paper and debentures. These are meant for investors who do not want to take risks with their investments and expect steady and reliable returns. These funds are generally held for longer periods, say a year or more.
So what if you have come into a sudden windfall and want to park your funds for a short while until you find a profitable investment option? For example, if you are pondering over what equities to buy or waiting for your real estate broker to come up with a great property deal? In that case, the best place to park your money would be liquid mutual funds. They 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 mutual 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.
Call money: Call money is an overnight loan taken by banks to ensure adequate liquidity. Participants in the call money market include banks and primary dealers. The loans are taken through an auction process, where the bidder who offers the highest interest rate gets the loan.
Non-convertible debentures: A non-convertible debenture is a debt of a fixed period offered by companies who want to raise money for working capital or to meet capital requirements for growth.
Liquid mutual 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 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 mutual funds are exposed to interest risk too. 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, in the case of liquid funds, these fluctuations are kept 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 these 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. However, it is worth remembering that the debt of infrastructure company IL&FS was given a very high rating by the credit rating agencies, and it ended up defaulting.
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.
Liquid funds taxation
Debt funds that are held for under three years are subject to short term capital gains tax. Liquid funds taxation is unavoidable as they are held for much shorter periods than three years. The gains from these 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 taxation is that interest income up to Rs 10,000 earned from savings accounts in a financial year is exempt from tax under Section 80TTA. So you can get the full benefit by keeping your funds in a savings account until your interest income reaches Rs 10,000 a year.
But even with the tax disadvantages, these funds can offer better returns than bank savings deposits. In the past few years, liquid 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 attracts 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.
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: These funds 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 the mutual fund 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: They 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: Liquid mutual 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 investment, you could consider this type of fund.
How to invest
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 a high credit ratings, but it won’t hurt to check what’s in the portfolio of the funds you are purchasing. Look for those that have high proportion of government securities and treasury bills; they carry less risk.
Compare returns: Check the returns for the past few years. Many websites offer comparisons of mutual funds, and you can check the kind of returns each offer. 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. Choose those companies that are large and have a good reputation in the market. Mutual fund distributors like Angel Bee can help you find the right kind of fund for you.
Maturity of investments: These 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, they do 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 types of funds invest in highly rated paper. So make sure that all the fund’s investments have an A1 or AAA rating.