A liquid fund is a category of mutual fund schemes that invest in debt and money market securities with maturity of up to 91 days only. Investments by these funds are in debt instruments with residual maturity of less than 91 days at the time of investing, which include Treasury bills (T-bills) Commercial Paper (CPs), Certificate of Deposits (CDs), Bank Term Deposits among others.
The amount invested in a liquid fund before 2:00 pm of a trading day is processed as per the previous day’s net asset value (NAV), as long as the funds are credited to the asset management company’s (AMC) collection account before 2:00 pm and the application reaches the AMC’s branch before time. So, if a purchase transaction in a liquid fund is submitted on X day, the applicable NAV is of the day prior.
In case of redemption, the redemption is credited in the investor’s account on the next working day. For instance, redemptions received on Friday before 3.00 pm will be processed on Sunday’s NAV and the payout happens on Monday.
The main source of earnings for a liquid fund is through the interest income on their debt holdings and a very small part of their income may be generated via capital gains. What this means is that when interest rates fall, bond prices go up and when interest rates rise, bond prices fall.
Liquid Funds are not totally risk-free. For instance, as liquid funds predominantly invest in debt instruments, they are a subject to interest rate risk. So, any change in the prevailing interest rates may cause a rise or fall in the price of the debt instruments, thereby impacting returns of the fund, which vary on a daily basis. Debt instruments also carry credit risk. However, credit risk can be considerably mitigated through conservative investment policy like investing in sovereign securities and high grade credit instruments viz. AAA rated securities.
Like other mutual funds, investments in liquid funds are also subject to income tax. The tax implication depends on the holding period of your investments in the fund, and the type of your investment plan, which could be growth or dividend. In case an investor has opted for dividend, taxation will be dependent on prevailing government policy on dividend taxation for that particular class of investor.
In case of a growth plan, liquid funds are subject to possibly two different forms of taxation: short-term capital gains tax and long-term capital gains tax.
If you invest in the growth plan of a liquid fund and if you redeem your investment before three years (36 months), then you have to pay short-term capital gains (STCG) tax, which will be taxed at the income tax slab rates. This means, the gains are added to your income and taxed at the income tax slab rate that you fall under.
If you redeem your investments in a liquid fund after three years (36 months), then you are subject to long-term capital gain tax (LTCG), which includes indexation benefits, and is taxed at the rate of 20 per cent. The indexation benefit adjusts the gains for inflation, using the cost of inflation index (CII) as provided each year by the government, before calculating the capital gain. This generally reduces the tax incidence on your long term capital gains.
This nature of taxation makes liquid funds suitable for better post tax returns and additionally a flexible holding period vis-à-vis other fixed rate-fixed tenure debt-oriented investments.
Optimal management of cash surpluses could add significantly to the overall returns for investors. Let us first understand this aspect in the case of a company, which needs to keep part of its money in non- interest earning bank accounts viz. current account. This is required since companies need to have easy access to cash for day-to-day working as well as any urgent need for cash that may arise for business requirements.
The same approach can be adopted by us for efficient gains when we suddenly receive a large sum of money. This could be owing to circumstances such as receiving an annual bonus, or the sale of an asset which needs some detailed deliberation before suitable deployment or even the maturity of a bank deposit, among many other possibilities.
The very nature of liquid funds makes them an ideal vehicle to park money for a short while before you make up your mind on exactly where to deploy it for the medium to long term.
Like selecting any other mutual fund, you need to check the following:
Liquid funds carry one of the lowest investment risks among all types of mutual funds. Factors that contribute to liquid funds emerging as popular choice for institutional as well retail investors include –
The choice of growth, dividend and dividend re-investment options can be used to suit your specific investments requirements, making liquid funds suited to a variety of investment needs for short-term investing of cash surpluses.
Rajnish Narula is the CEO of Canara Robeco Mutual Fund. He has 35 years of experience in the banking and asset management business in India. Rajnish holds a bachelor of commerce degree from Loyola University and a Master of business degree from Hagan School of Business, Iona College, New York.
Aashika is the India Editor for Forbes Advisor. Her 13-year business and finance journalism stint has led her to report, write, edit and lead teams covering public investing, private investing and personal investing both in India and overseas. She has previously worked at CNBC-TV18, Thomson Reuters, The Economic Times and Entrepreneur.