What are Liquid Funds?
Liquid funds can be simply defined as Debt Mutual Funds that invest the investor’s money in short term Money Market Instruments like Treasury Bills, Government Securities and Call Money that hold the least amount of risk. Liquid Mutual Funds are Money Market Instruments which are highly liquid in nature and have maturity period of less than a year such as Certificate of Deposits (CDs), Commercial Papers, Term Deposits, Call Money, Treasury Bills, and so on.
How Do Liquid Funds Work?
The Liquid Funds work in the same way as bank deposits. The Liquid Funds invest the investor’s money in short terms debt instruments that mature in less than a year. The maturity period for different funds can be lower than this as well. But on an average, these money market debt instruments have a maturity of 90 days or less. The shorter the term of the debt instrument lesser is the risk of investment. However one should keep in mind before investing that the funds are among the lowest volatile investments and they are not completely risk-free.
Risks in Liquid Mutual Funds
Investing in Liquid Funds generally carries less risk and lesser gains than Bond Mutual Funds. The investments made in the debt market do not always gives steady returns as these investments are based on market fluctuations; the value can rise or fall depending on the market condition. So the returns are not always guaranteed.
- Interest Rate Risk:Interest rate risk defines the possibility of change in the price of a bond due to a change in prevailing interest rates. The prices of the bonds are inversely related to the interest rate. When the rate of interest is higher, the prices of the bonds go down and vice-versa. As Liquid Funds invest in low maturity debt investments and Money Market Securities, the interest rate risk is negligible.
- Credit Risk:the Money Market Liquid Funds are low-risk investments and are generally high quality securities that aim to preserve the value of the investments. There is no guarantee that the investor will receive the capital invested when the funds attain maturity. This happens when the issuer of the bond is unable to pay back on time or defaults. This causes a decline in the credit ratings of the issuer which in turn reduces the price of the bonds.
- Inflation Risk: due to the primary components of liquid funds, i.e., safety and short term nature, the returns are lower on these investments then the riskier options like stocks and bonds. So these Money Market Instruments may not be the investment options for beating inflation. Inflation risk is the danger that an increase in price levels will undermine the purchasing power of a bond's fixed interest payments.If inflation rises by more than expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had anticipated.Hence, bond prices will fall, leading to a lower NAV of the mutual fund.
SEE ALSO: Best Liquid Funds 2019: Top 10 Liquid Funds
Why Invest In Liquid Funds?
Given below are some of the main benefits of investing in liquid funds:
- Professional Management: it is important to keep in mind that debt investments are not completely risk averse and thus they must be managed carefully. Thus the professional fund managers are needed to mitigate these risks and also generate good returns. The fund managers can manage your debt portfolio according to the changing market scenario.
- Tax savings: Debt mutual funds also get some favourable tax treatment which in turn helps you increase your net returns.Your short-term capital gains from debt and Liquid Mutual Funds are taxable as per your tax slab.
- Accessibility of Unavailable Debt Securities: sometimes securities have very high minimum investment price that is out of the reach of most investors. However, in case of Liquid Mutual Funds, the investors are benefitted by investing in multiple securities which helps them diversify their portfolio.
Who Should Invest In Liquid Funds?
Listed below are the types of investors who should invest in Liquid Funds:
- Suitable for Investors with Low-Risk rofile: the Liquid Funds are suitable for investors who want to park their money for a very short period of time and needprotection. The liquid funds are a good investment option for people who do not want to compromise on their returns that they would earn. Securities with short tenure are less volatile and more predictable.
- Suitable for Investors with Short Term Goals: investors who want to fulfil some short term goals can invest in Liquid Funds. They can park their idle money and earn inflation-beating returns on the deposits. Short term refers to a period of less than a year and Liquid Funds are ideal options for short term goals,since they are less volatile than other riskier products.
- Suitable for Investors Wanting to Build Contingency Funds: an investor can also invest a portion of the contingency funds into Liquid Funds in contingency funds. These funds invest in money market instruments and are suitable even for a short-term investment horizon of 90 days or less.
- Suitable for Investors Who Wish to Diversify Funds: Liquid Funds work great for investors looking for diversification of their entire portfolio.If you have a very short term of say 3 months, then Liquid funds are the best bet to park your short term Liquid Funds.Liquid Funds prove to be beneficial as they generate better returns as compared to a bank savings account.
- Suitable for Investors with Liquidity Needs: Liquid Funds are suitable for investors who need money in the immediate future.These investment instruments have high liquidity and can be converted into cash within months. Thus the quick redemption policy makes it even more favourable among investors.
SEE ALSO: Is It Good To Invest In Liquid Funds?
When to Invest In Liquid Funds?
Before investing in Liquid Mutual Funds it is important to understand the changing interest rates. The interest rate and the prices of the bonds have an inverse relationship. So when the rates of interest are high in the economy the prices of the bond issued are low and vice versa. Let us analyse Liquid Funds under the rising and falling interest scenarios:
- Raising Interest Rate Scenario:In the rising interest rate scenario, the financial system might face a short term liquidity crunch due to monetary tightening measures.Under such circumstances, liquid funds performance remains unaffected. Hence, they prove to be a better investment option to park your short term surplus funds.
- Falling Interest Rate Scenario:On the other hand, in falling interest scenarios there is liquidity pressure in the system and hence liquid and liquid plus scheme start losing their sheen.
Bank FDs vs. Liquid Funds:
Given below is a summary of bank FDs vs. liquid funds:
Liquidity of Liquid Mutual Funds:
In this age where all the services are based on apps and websites, Mutual Funds can also be managed through apps. Previously, the process of buying and selling of the Liquid Funds took hours or days. But now the fund house offers instant withdrawals under the liquid funds scheme. With this online facility, the fund houses take below 30 minutes to transfer the redemption amount to your bank account. Let’s see how instant redemption works:
- Uses the Immediate Payment Service (IMPS) provided by various banks
- You can receive the funds in your bank account in a very less time, generally below 30 minutes.
- You can either withdraw an amount of 2 lakhs or the redeemable balance, whichever is low
- The facility of converting the Liquid Funds into instant cash is available throughout the year and round the clock.
So, due to this facility, the Liquid Mutual Funds are one of the best options for investors to park their funds in the Short Term Money Market Instruments.
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