What is Liquid Mutual Funds and How to Invest: Meaning, Returns and Taxation

Debt funds investing in short-term assets like repos, government securities, treasury bills, etc. are known as liquid mutual funds. As per SEBI's regulations, you can invest liquid funds only in the money market and debt securities that comes with a maximum maturity period of 91 days.

Though the market price of the securities determines the returns of liquid funds, you can earn a handsome return on long-term bonds than short-term ones. Apart from this, liquid funds are considered more stable than any other debt funds considering their quick redemption and flexible holding period.

Here’s more about liquid funds!

Features of Liquid Mutual Funds

Take a look at the notable features of liquid funds to make your investment decision efficiently:

• As the name suggests, liquid funds are highly liquid like bank accounts and can be withdrawn even after one day of investment. However, you will earn interest for that single day in such cases. Once you submit the withdrawal request, the funds will be credited to your account within one day.
• Instead of keeping your money idle you can invest it into this short-term investment plan and earn interest. Liquid fund is a preferred investment instrument for several investors as they allow a short period of investment and returns.
• The returns on liquid funds entirely depend on the market performances. So, these funds do not assure you of fixed returns.
• Liquid funds invest in debt instruments, so they are considered less risky than equity funds. However, if you compare it to a fixed deposit, the risks involved in liquid fund investments are higher as they depend on market volatility. If you can take a bit of risk and wait until reaching the maturity period, the possibilities of benefits are on a higher note.
• These funds do not go through much fluctuations and when the maturity of selected securities matches the maturity of funds, you can receive higher returns.
• In maximum cases, you can pull out the funds after a week of investment without paying any exit load. They do not charge any processing fee or penalty for the early withdrawal of liquid funds. 
• Unlike other mutual funds, liquid funds are not subjected to tax deductions. So, TDS is not applicable for these funds. 

All these combined reduce your investment costs for liquid funds and makes them an attractive investment instrument.

Advantages of Liquid Mutual Funds

Here are some of the benefits of the best liquid mutual funds you should know before planning your investment:

•         Lower Costs

Generally, these funds maintain an expense ratio of less than 1%. This maximises the chances of a considerable return to the investors. Lower the expense ratio, higher will be your returns.

•         Holding Period Flexibility

Liquid funds feature a flexible holding period with a negligible exit load charged for redeeming the amount within seven days. You can hold your investment as long as it is necessary. Resultantly, you can enter and exit the investment as per your preferences. 

•            Lower Risks

Liquid mutual funds are focused to provide steady returns and hold your funds safely for a short period. Consequently, it maintains a stable value despite market fluctuations. Being a short-term investment instrument, it can maintain stability across multiple interest rate cycles. 

However, funds that hold securities with longer maturity often swing between declining market rates and earning strong capital gains. As a result, they experience a considerable capital loss when the interest rates rise.

•          Quick Redemption

With liquid funds, you can redeem the interest instantly within the next working day or even the same day. Lower default probability and higher liquid security of these funds make it possible.

Working Principle of Liquid Mutual Funds

If you want to invest in liquid mutual funds, you must know how these funds actually work, where they invest, etc. So, here's a detailed overview of these funds' working procedure:

Investment Fields

Liquid funds are regulated by SEBI (Securities and Exchange Board of India). As per SEBI's norms, it can hold short-term securities with high liquidity and good credit quality as follows:

• You can invest liquid funds in listed commercial papers. They feature an overall 25% exposure limit in the investment sector. SEBI does not allow them to invest in any risky assets.
• To meet quick redemption demands, liquid mutual funds need to hold at least 20% of their assets in cash or cash equivalents. This can be any liquid product like money market securities, etc.

Earning Sources

The main earnings of liquid funds come from the interest paid on their debt holdings. However, a small part of their income also comes through capital gains. Here is a better interpretation of this earning feature:

• There is an inverse relationship between interest rates and bond prices because when the former rises the latter falls and vice versa. This relationship status is stronger in the case of long-term bonds. So, it implies a bond with longer maturity is highly responsive to market fluctuations.
• Liquid funds are permitted to invest in short-term securities only. So, it has less or nothing to do with these changes in interest rates. This also implies liquid funds are not much affected by capital gains or losses. Consequently, these funds come with lower interest rate risks. However, when the interest rate rises, liquid funds can outperform any other debt funds. This is because their market value does not suffer much due to capital losses and their interest rates rise.

Factors to Consider Before Investing in Liquid Mutual Funds

Check out the factors you should consider before investing in the best liquid mutual funds:

• Expense Ratio

Expense ratio is the fund management fee charged by the liquid funds annually. Every mutual fund charges this for its fund management services. Liquid funds come with a lower expense ratio as the fund managers hold the security till maturity after investing liquid funds. So, liquid funds do not incur any additional expenses for management and AMCs charge a lower service charge.

• Returns

As per data, savings account deposits offer you a 4% return, whereas the returns from liquid funds remain between 7% and 9%. So, these funds definitely offer better returns.

• Risks

Considering the shorter investment period of up to 91 days, liquid mutual funds do not get much affected by market volatility. As the Net Asset Value of these funds remains steady, they are counted as low-risk investment options. However, you must remember that liquid funds are not risk-free as their NAV can drop once any of the underlying security's credit rating drops.

• Investment Plan

Liquid funds feature a three-month investment horizon and you can use them to create emergency funds. Moreover, they are highly liquid like your savings account deposits and you can earn a handsome return from these funds at lower risks. So, create your investment plans accordingly before investing in these funds.

Bottom Line

If you are looking for short-term investment plans with a solid return, liquid funds are a viable option. Business persons can invest in these funds for better cash management and earn interest on their idle cash funds.