Liquid funds are a category of mutual funds that invest in short-term, high-quality debt instruments such as treasury bills, commercial papers, and certificates of deposit. The primary objective of these funds is to provide liquidity and safety while offering better returns than traditional savings accounts. They typically have a short maturity period of up to 91 days, which makes them highly liquid and less sensitive to interest rate fluctuations. This article explores the benefits and risks of investing in liquid mutual funds, providing a comprehensive guide to help you make informed decisions and potentially boost your wealth.
Benefits of investing in liquid funds
Low risk: One of the significant advantages of investing in liquid funds is their low-risk nature. Since these funds invest in high-quality debt instruments with short maturities, the risk of default is minimal. This makes them a safer option compared to other mutual funds that invest in longer-term and lower-rated securities.
High liquidity: Liquid funds are designed to provide high liquidity, allowing investors to access their money quickly. Redemptions from liquid funds are usually processed within 24 hours, making them ideal for those who need quick access to their funds.
Better returns than savings accounts: Liquid funds generally offer better returns than traditional savings accounts. While the returns are not guaranteed, they tend to be higher due to the nature of the underlying investments. This makes liquid funds a more attractive option for parking short-term surplus funds.
Tax efficiency: Liquid funds are tax-efficient than fixed deposits and savings accounts. The returns from liquid funds are subject to capital gains tax, which can be lower than the interest income tax on fixed deposits, depending on the holding period and the investor’s tax bracket.
No lock-in period: Unlike fixed deposits, liquid funds do not have a lock-in period, giving investors the flexibility to withdraw their money whenever needed. This makes them suitable for emergency funds and short-term financial goals.
Risks associated with liquid funds
Interest rate risk: Although liquid funds are less sensitive to interest rate fluctuations compared to other debt funds, they are not entirely immune. Changes in interest rates can impact the returns of liquid funds, especially if the fund manager has invested in slightly longer-term instruments within the permissible limit.
Credit risk: Liquid funds primarily invest in high-quality debt instruments, but there is still a risk of credit downgrades or defaults. If the credit rating of the underlying securities is downgraded, the fund’s value can be adversely affected. However, the risk is relatively low due to the investments’ short maturity period and high credit quality.
Market risk: Liquid funds are subject to market risk, which means that the value of the investments can fluctuate based on market conditions. While the risk is lower compared to equity funds, it is essential to be aware that the value of your investment can go up or down.
Limited returns: While liquid funds offer better returns than savings accounts, the returns are generally lower compared to other mutual fund categories like equity or hybrid funds. Investors looking for higher returns may need to consider other investment options with a higher risk profile.
Conclusion
Investing in liquid funds can be a smart strategy for those looking to park their surplus funds in a low-risk, highly liquid investment option. With better returns than traditional savings accounts and tax efficiency, liquid funds offer a compelling choice for short-term financial goals and emergency funds. However, it is essential to be aware of the risks associated with mutual fund investments, including interest rate risk, credit risk, and market risk.
