What are the Disadvantages, Advantages, & Risk of Liquid Funds

What are the Disadvantages, Advantages, & Risk of Liquid Funds

Liquid Fund is a better alternative to traditional savings avenues as they provide a high degree of liquidity and are considered safe as compared to other mutual fund categories. However, returns on a liquid fund are not definite. To have a clear understanding of this type of mutual fund read on further.

Liquid Funds: What Are They?

A Liquid Fund is a debt fund that invests in fixed-income securities like treasury bills, commercial papers, certificates of deposits and other securities with a maturity period of up to 91 days. They are open-ended schemes that permit you to park your fund for a short period. 

As this scheme comes with high liquidity with no lock-in period, you can choose to redeem your investment whenever you want. This redemption request is processed within one working day. So, liquid funds are suitable for individuals depositing money for a short duration and need access to cash on an emergency basis.

How do Liquid Mutual Funds Work?

The primary objective of liquid funds is to provide liquidity and capital protections to investors. Fund managers choose high-quality debt securities for making an investment accordingly to the scheme obligation. They also ensure that the average maturity of the scheme's portfolio is not more than 91 days. It is because the shorter the maturity period, the less likely it is that interest rates will change. Then by matching the best liquid funds' maturity with the maturity of individual securities, fund managers try to deliver higher returns.

Liquid funds generally earn through interest payments on their debt holdings. Capital gains account for a very small part of their earnings. Let’s get a better understanding of this as it is a defining feature of liquid funds.

When interest rates decrease, bond prices rise and vice versa. Long-term bonds possess a strong negative correlation between bond prices and interest rates. This indicates that the longer the maturity of a bond the more it responds to change in market yields. Since a liquid fund invests in short-term securities, the market value of a liquid fund does not significantly change when interest rates change. This indicates that there are no significant capital gains or losses in liquid funds.

What Are the Advantages of Liquid Funds?

The following are some of the notable advantages you can enjoy while choosing to invest in a liquid fund.

  • Higher Returns During Inflationary Markets

During high inflation, liquid funds are the feasible investment instruments allowing investors to earn a steady return of 7 to 7.5%. The Reserve Bank maintains a high-interest rate and tightens liquidity. In turn, this results in favourable returns from the liquid mutual funds.

  • Minimal Risk

A liquid fund is a low-risk debt fund as most of the investment of liquid funds is in government securities. Owing to this fact, liquid funds invest in papers which mature in less than 91 days, and the risk associated with these funds is quite low. On the contrary, longer maturity periods enhance credit rating fluctuations risks that will be affecting your money.

  • High Liquidity

Liquidity refers to how easily financial assets are converted into cash without causing a big loss in value. Liquid funds are highly liquid and have no lock-in period. This indicates that you can withdraw your investment within 24 hours of the request. So if you choose to redeem on say Friday, then your redemption amount will be credited on Saturday. 

  • Low Expense Ratio and Exit Loads

Liquid funds are managed by professionals and therefore fund houses charge management fees as a part of the fund's expense ratio. A fund’s expense ratio and investment returns are inversely proportional to each other. Liquid mutual funds carry a very low expense ratio and hence they offer higher profitability. Liquid funds have exit loads of less than 7 days. Therefore, you can easily redeem your investment from liquid funds within just 7 days without paying any penalty charge.

  • Tax Benefits

Liquid funds has debt taxation and the holding period stands at 3 years. After three years when you redeem, you enjoy the benefit of indexation as the profit would be treated as long-term capital gain.

What Are the Risks of Liquid Funds?

Like all mutual funds liquid funds involve investment risk. So you should be aware of various risks and potential losses associated with liquid fund investing.

  • Interest Rate Risk

Interest rate risk mostly signifies the possibility of a change in a bond's price due to fluctuation in prevailing interest rates. With high-interest rates, bond declines and vice versa. However, as the liquid funds invest in money market securities and low-maturity debt, the interest rate risk is negligible.

  • Inflation Risk

Liquid fund returns are typically lower than other volatile investments like stocks and bonds due to their safety and short-term nature. As a result, there is a possibility that rate of return may not keep pace with inflation. The inflation risk increases with the bond’s maturity period. As liquid funds invest in short-term investments, the risk of inflation is relatively low.

  • Credit Risk

Unlike traditional savings or fixed deposit accounts, liquid mutual funds are not insured. Despite the fact that money market mutual funds invest in high-quality securities, risk is inevitable. There is no assurance that you will get the invested capital when you opt for redeeming your MF units.

A bond is considered to be in default when the issuer is not able to pay back the principal or interest on time. The prices of an issuer’s bonds and NAV of the liquid fund that holds the issuer’s bonds will both decrease if the issuer’s creditworthiness or credit rating decreases.

Despite such risks, liquid funds are secured debt instruments offering flexibility in terms of quick redemption of investment and exit options.

Final Word

Liquid funds can generate a stable income for you with almost no chance of defaults. However, such income is comparatively lower than other securities. So, if you are an investor with a low-risk appetite and want to earn a stable income for short period, a liquid fund is a viable option for you.