Liquid is something that you would associate with free movement or free flow. Water is a liquid that can flow easily while ice is a solid that cannot flow. It takes time to change its state. Interestingly, the same logic can be applied to your investments as well. Your investment is liquid if it is easy for you to get in and out of it. On the other hand, it is illiquid if getting in and out of it is likely to take some time. From this, it must be clear that liquid mutual funds are instruments that are easy to purchase and exit.
What’s in a definition? Well, everything.
A liquid mutual fund invests your money in money market instruments with a maximum maturity of not greater than 91 days. The maturity profile or the time remaining for the assets in the fund to mature, is generally short-term. Thus, you can be assured that these funds would generally invest in high quality debt instruments like Bank Certificate of Deposits (CDs), Commercial Papers (CPs) and Non-convertible Debentures (NCDs). They also invest in Treasury bills, Tri-Party Repos (TREPs), and other short-term instruments.
Profiling is important
Liquid funds generally have a maturity profile between 1 to 3 months. They prefer to keep the safety of the investment at the forefront, followed by liquidity, and finally the returns. The fund managers are aware of the profile of the investors and nature of requirement; therefore, the investment is done in highly liquid and A1+/AAA rated papers.
To further safeguard your interests as an investor, the regulator has introduced a Potential Risk Class Matrix. There are two things that you need to understand about this risk matrix.
- Based on interest rate risk, the grid is divided into three sections, namely, A-I, A-II, A-III. A-I has the lowest interest rate risk and A-III has highest interest rate risk.
- Based on credit risk parameters the grid is divided into A, B, and C. A has the lowest credit risk and C has the highest credit risk.
So, if a fund is B-I then it will have low interest rate risk and moderate credit risk.
The value of liquid mutual funds
You can consider liquid funds for parking your surplus or idle funds. Further, if you are a current account holder then you may consider investing in liquid funds to generate some returns. The other use of liquid funds is to park the money for systematic transfer plan (STP) to equity funds. Features of liquid funds that you must know:
- Liquid funds have a small tapering exit load for a period of six days. Therefore, if you are investing for a short period of time, you need to account for the exit load as well. There is no exit load seventh day onwards.
- The fund has a T+1 settlement cycle.
- Liquid funds also have an instant redemption facility. As the name suggests, in this facility the money is credited to your account in a few minutes time. However, the limit on withdrawal is set at 90% of the value of the portfolio or INR.50,000 per day, whichever is less.
- Liquid funds have a low management fee. This also can be one of the criteria to look at while making an investment decision.
- The taxation for liquid funds is the same as other debt funds .
Liquid funds offer liquidity and low interest rate risk thereby making it a good product to invest in for a short period of time.
While there are numerous liquid funds available in the market, the returns in this category for a short period of time should not be the key differentiating factor. You need to look at the lineage and vintage of the fund house, the investment process, and the quality of the portfolio along with the risk that the fund is taking to deliver these returns.