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What are Liquid Funds? Understanding Liquid Fund Taxation

Liquid Funds

Liquid funds are a type of loan fund. You need to know how long you plan to spend, as investments are grouped by time. Debt funds are divided into 16 groups, ranging from overnight funds to those with a duration of 7 years. SEBI made this change to help buyers easily find the right fund without feeling confused by too many options.

In this blog, we will look at Liquid Mutual Funds and cover everything you should know before buying in them.

What are Liquid Funds?

A Liquid Mutual Fund is a type of investment fund that puts money into safe, short-term debt options like commercial paper, government bonds, and bank bills that usually mature within 91 days. The net asset value or NAV of a liquid fund is measured for 365 days. Investors can have their withdrawals handled in 24 hours. These funds have the least interest-rate risk among debt funds.

How do Liquid Funds work?

To understand how liquid funds work, it’s important to know where they spend and how they make money.

1. Where do Liquid Funds Invest

A liquid fund will usually hold securities that are short-term, of good credit quality, and highly liquid. New rules from SEBI have strengthened these fund features.

Liquid funds can only invest in publicly available commercial papers and can invest a maximum of 20% in any one industry. They are not allowed to deal in risky assets according to SEBI rules. These rules are designed to manage credit risk in the liquid fund account.

Additionally, liquid funds need to keep at least 20% of their assets in liquid goods like cash and similar investments, such as money market securities. This makes sure they can quickly handle any requests for cashing in.

2. Ways to Make Money

Liquid funds mainly make money from interest on their debt investments, with only a small amount coming from capital gains. Liquid funds have a key characteristic. Let’s take a closer look at it.

When interest rates decrease, the prices of bonds rise. When interest rates go up, bond prices go down. The negative relation between bond prices and interest rates is bigger for long-term bonds. This means that the longer a bond’s age, the more it reacts to changes in market interest rates.

A liquid fund mainly invests in short-term stocks, so its market value doesn’t change much when interest rates go up or down. This means that liquid funds do not make or lose much money. When interest rates go up, flexible funds usually do better than other debt funds because they earn more interest while only losing a little value in the market. In market language, we say that liquid funds have a very low interest rate risk.

Benefits of Liquid Funds

1. Low Risk:

A liquid fund is a low-risk debt fund that focusses on giving the safety of principal and steady returns. So, the value of a flexible fund stays relatively steady even when interest rates change in the market. Funds with long-term securities can earn big gains when interest rates go down but can also suffer significant losses when interest rates go up.

2. Inexpensive

Liquid funds are inexpensive debt funds because they are not managed as constantly as other types of debt funds. Most liquid funds usually have cost ratios less than 1%. This low-cost setup helps them give the best returns to the client.

3. Flexible Holding Period

An investor in a liquid fund can keep their cash for as long as they want. Liquid funds have open holding periods, but a small fee is charged if you withdraw money within seven days. This allows you to easily start and end the investment while making safe returns that are linked to the market for as long as you invest.

4. Fast Redemption

Redemption requests are handled within one business day, and some funds allow for quick redemption. This is possible as liquid funds are invested in highly liquid securities with a low default chance.

 

Liquid Funds

Who Should Put Money in Liquid Funds?

1. Investors who plan to invest for a short period of time:

Liquid funds are ideal for people looking to spend for up to 3 months because they invest in securities that have similar time frames. Investors who plan to spend for 6 months to a year should consider putting their money in slightly longer-term funds, like ultra-short duration funds, to earn better returns.

2. Investors who put their money in Bank Deposits:

Investors who put their extra money in bank deposits can gain from liquid funds in two ways: they can take their money more easily and earn better returns. In a regular bank fixed deposit, your money is kept for a set time, and if you take it out early, you will lose some interest. In contrast, liquid funds allow you to hold your money for as long as you want and make it easy to take it out whenever you need. You can take money out of bank savings accounts whenever you want, but they usually make about 3% to 4% interest. This is less than the 5% or more that you can get from a liquid fund.

3. Investors who want to maintain Contingency Funds:

Liquid funds aim to give easy access to money and safety, while earning a little interest. Investors can keep their emergency money in a flexible fund, knowing it will be safe and can be taken out when needed.

4. Investors who want to temporarily set aside money:

Liquid funds are safe cash management options that allow you to earn a little interest on your money. Therefore, a large amount of money, like from a bonus, selling property, or inheritance, can be kept in a liquid fund for a while until the investor figures out how to spend it.

5. Medium-Route investments in Equity Funds:

Investors can keep money in a liquid fund and use a Systematic Transfer Plan (STP) to regularly move assets into an equity fund. This allows them to invest in stocks regularly, while the money in the liquid fund gets steady returns.

Things to Consider Before Investing in Liquid Funds

Liquid funds are very safe debt funds and are often considered as alternatives to bank savings. Low risk doesn’t mean no risk at all! Investors need to know that flexible funds come with some risks too.

Like all mutual funds, there is no promise of returns. Bank accounts will always give you the promised interest when they mature. In contrast, the return from a liquid fund can change because it relies on market interest rates. That’s why buyers should look at a fund’s history and choose those that have performed well over time.

Second, flexible funds can still face credit risk. In 2018, when IL&FS was downgraded, it was found that some flexible funds had put money into lower-rated debts to increase their profits. When these stocks stopped paying interest, their credit rating went down, and the cash value dropped. Investors can lower credit risk by selecting liquid funds that have the best quality assets.

Third, flexible funds do not help you build wealth. Instead, they offer safety and easy access to your money with a small return. Investors need to make sure their financial goals and return expectations match what liquid funds offer.

Finally, when looking at liquid funds, you should consider both the returns and the cost ratios. Liquid funds are mainly generic products, so most liquid funds make similar returns at any given time. So, a fund with high fees will likely have much lower profits. For example, look at two flexible funds. One has a yield of 6%, and the other has a yield of 6.5%. If their cost ratios are 0.3% and 0.9%, then their running yields (the yield after subtracting expenses) are 5.7% and 5.6%. Notice how a high expense ratio has lowered the investor’s yield.

Taxation on Liquid Funds

Investors make money from liquid funds through income and capital gains. Investors do not have to pay taxes on dividends they earn from mutual funds. If an owner makes a profit by selling their fund units for more than they paid, that profit is taxable.

1. Short-term Cash Gains:

If a trader sells or redeems units of a liquid fund within 3 years, it is considered short-term capital gains. This is taxed at the income tax slab rate applied to the investor.

2. Long-term Capital Gains Tax:

If you sell a liquid fund after holding it for more than 3 years, the profit is considered a long-term capital gain, and you can take advantage of “indexation.” This means that the buying price goes up to account for inflation (using a government index) before figuring out the capital gain. Long-term capital gains are taxed at a rate of 20%.

How to Choose the Right Liquid Fund?

When looking at a liquid fund, the key things to consider are how much it earns, its costs, how large it is, and how well the investments are spread out.

1. Returns:

Liquid funds deal in short-term loans that last up to 91 days, so investors should check the one-month or three-month returns to see how well the fund is doing. Returns over a longer period (like one or three years) are not suitable for a flexible fund. A good liquid fund should do better than its standard and other similar funds. Investors should also check that the fund has performed well over time. You can check this by reviewing the results from one to three months over the last few years.

2. Expense Ratio:

Liquid funds from different companies have similar returns because they all invest in the same types of short-term debt assets. Therefore, it’s important to compare their cost ratios. This is the yearly fee that the fund charges for managing the investments. A higher expense ratio means that the investor will get a lower profit in the end.

3. Size of the Fund:

Institutional buyers mostly use liquid funds. If a big investor suddenly takes out a lot of money from a small liquid fund, the fund would lose a major amount of its assets. This would hurt the fund’s ability to invest and make profits. Hence liquid funds with relatively larger assets under management (AUM) are better to small-sized funds.

4. Portfolio Diversification:

Liquid funds are kept to ensure the spent money remains safe and stable. Investors should check a flexible fund’s portfolio to make sure it includes various investments from different companies. This will reduce the risk to the stock if any issuer fails to meet their obligations.

Top 5 Liquid Funds

The best liquid funds in India based on returns are:

  1. Quant Liquid Direct Fund-Growth
  2. Edelweiss Liquid Direct-Growth
  3. Mahindra Manulife Liquid Fund Direct -Growth
  4. Aditya Birla Sun Life Liquid Fund Direct-Growth
  5. Union Liquid Fund Direct-Growth

Conclusion

Liquid funds are debt funds that deal in short-term debt and money market securities that last no longer than 91 days. It deals in short-term, good quality, and liquid securities; hence, the value of their units tends to be less volatile as compared to other debt funds. Most of the money a fund earns comes from interest, while capital gains make up a small portion of the total earnings. Liquid mutual funds are inexpensive, low-risk investments that are easy to access and have open choices.

Liquid funds aim to keep your money safe, easily accessible, and offer a small return. So, they are often seen as alternatives to short-term bank savings. They are best for investors who need to spend money for a short time, want to keep a large amount of money safe for a little while, or want to move money into longer-term investments.

FAQs

1. What do flexible funds mean?

Liquid mutual funds are debt funds that invest in short-term assets like treasury bills, buyback agreements, COD, or commercial paper. These funds can only deal in debt and money market instruments that mature in 91 days or less, according to SEBI rules.

2. Where does a flexible fund put its money?

Liquid mutual funds can only invest in listed commercial papers and cannot invest more than 20% in any one industry. They can’t deal in risky assets due to SEBI rules. These rules aim to reduce credit risk in the liquid fund portfolio.

3. Is the Liquid Fund safe?

Liquid Funds are some of the safest mutual funds. They lend to reliable companies for very short times, which lowers the risk.

4. Is a liquid fund better than a set deposit?

Liquid mutual funds offer profits that are very similar to those of short-term fixed deposits. They can be a good option instead of FDs for two reasons. First, you don’t have to promise for a specific period, and second, there is no fee if you decide to leave after seven days of investing.

5. Is there a waiting period for available funds?

No, there is no waiting period for these funds. You can use it anytime you like.

Disclaimer – Mutual Fund investments are subject to market risks; read all scheme-related papers carefully.

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