Liquid Funds: Meaning, How They Work, Benefits, and Risks of Investing In Them

Liquid funds may be a suitable alternative for short-term investments because they offer easy access to money and generally have lower risk than many other mutual fund categories. However, they are not risk-free, and their returns are not guaranteed.

Let’s understand in detail what liquid funds are, how they work, and the advantages and disadvantages of investing in them.

What Are Liquid Funds?

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

Since they have no lock-in period, you can redeem your investment on any business day. These redemption requests are typically processed within one working day (T+1), making liquid funds useful for parking short-term surplus cash.

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.

High Liquidity

Liquid funds generally process redemption requests within one working day. Some fund houses also offer instant withdrawals, subject to certain limits and conditions.

No Lock-in Period

Liquid funds do not have a fixed lock-in period. You can redeem your investment when you need money, subject to the fund's rules and applicable processing times.

Low Risk

Liquid funds invest in short-term debt securities, so their interest rate risk is generally low. However, they still carry credit risk and can lose value.

Potential for Better Returns Than Savings Accounts

Liquid funds may offer higher returns than bank savings accounts. However, returns are not guaranteed and may be lower than those of savings accounts or fixed deposits in some cases.

Low Expense Ratio

Liquid funds generally have low expense ratios, but the charges vary from one fund to another. Lower expenses can help improve your returns after fees.

Low or No Exit Load After Seven Days

An exit load may apply if you redeem your investment during the first seven calendar days. Redemptions after this period generally do not have an exit load.

Useful for Systematic Transfer Plans (STPs)

Investors can use liquid funds to hold a lump sum and transfer smaller amounts regularly into equity mutual funds through a Systematic Transfer Plan (STP). This helps spread investments over time, but it does not guarantee profits or prevent losses.

What Are the Risks of Liquid Funds?

The following are the risks of investing in liquid funds.

Credit Risk

Since liquid funds invest in short-term debt securities issued by companies and banks, such as commercial papers and certificates of deposit, they carry credit risk. If a company fails to make its payments or its credit rating falls, the fund's Net Asset Value (NAV) may decrease.

Interest Rate Risk

Liquid funds invest in securities that mature within 91 days, so their interest rate risk is usually low. However, changes in interest rates can still affect the value of these investments.

No Deposit Insurance

Unlike eligible bank savings accounts and fixed deposits, which are insured up to ₹5 lakh by the Deposit Insurance and Credit Guarantee Corporation (DICGC), liquid mutual funds do not have government-backed deposit insurance. You may lose some of your invested money.

Liquidity and Redemption Risk

Liquid funds generally process redemption requests within one working day. However, during severe market stress, selling securities may become difficult, which can affect the fund's liquidity.

Taxation Risk

Gains from liquid fund units purchased on or after 1 April 2023 are generally taxed at your applicable income tax slab rate, regardless of how long you hold them. No indexation benefit is available for these investments, which may reduce your returns after tax.

Exit Load on Short-Term Withdrawals

If you withdraw your money within the first seven calendar days of investing, an exit load may apply. The charge depends on how soon you redeem your investment.

FAQs

What are liquid funds?

Liquid funds are debt mutual funds that invest in short-term securities and aim to generate returns for the investors.

Are liquid funds safe?

Liquid funds are generally low-risk, but they are not completely safe as they carry credit risk, interest rate risk, exit load risk, and others.

How are liquid funds taxed?

Gains from liquid fund units bought on or after 1 April 2023 are generally taxed according to your income tax slab rate, regardless of how long you hold them.