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What are liquid funds?

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 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.

How do liquid funds work?

So what then is a liquid fund? 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.

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 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.

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, liquid 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.

A low-risk option

Like all other debt funds, liquid 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. Hence, they are relatively immune from interest rate risk. The returns on liquid funds will be fairly constant, and your investment will keep increasing in value until redemption.

So does that mean that liquid 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 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, 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 are correspondingly higher.

What are the advantages of liquid funds?

  • High liquidity: The most obvious benefit of investing in liquid 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.

  • Good returns: Liquid 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: Liquid 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, liquid funds are your best bet since the Reserve Bank of India raises interest rates during inflationary times, and you will benefit from that.

  • Low fees: The costs of liquid funds are generally low. Mutual funds keep expense ratio and entry and exit loads low to attract investors.

How to invest in liquid funds

All liquid 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 liquid fund you are purchasing. Look for those that have a high proportion of government securities and treasury bills; they carry less risk.

  • Compare returns: Check the returns of the liquid fund for the past few years. Many websites offer comparisons of liquid funds. Mutual fund distributors like Angel BEE can help you find the right kind of fund for you.

  • Fund house: Make sure you select the right fund house with good expertise in mutual funds.

  • Maturity of investments: The liquid fund 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.

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