The class of debt funds that invest in short-term fixed-interest that generate money market instruments are known as liquid funds. The prime objective is to provide a high degree of liquidity along with the safety of the capital for investors.
Investment is made in high-rate debt instruments by the fund managers that mature in 91 days. The funds are allocated as per the investment objective. In order to reduce the sensitivity of fund returns and make them less vulnerable, the manager of the fund house ensures that the average maturity period is three months for the portfolio.
Liquid funds are an excellent medium to park and earn returns on your idle money. In order to ensure higher returns, the maturity of the underlying securities is matched with the maturity of the portfolio. It must be noted that the face value does not fluctuate much. Liquid funds come with lower risk and offer higher returns than the regular savings bank account.
Types of money market instruments in Liquid Funds
Commercial Papers - These are issued by companies and other financial institutions having high credit ratings. They are also known as promissory notes. Unsecured in nature, commercial paper is issued at a discounted rate and is redeemed at the face value. The difference in this trade is the return earned by investors.
Treasury Bills - These are issued by the government of India to raise revenue. They are issued for a short term, generally up to 365 days. T-Bill is a safe instrument because it is backed by the guarantee of the supreme. However, the rate of return is lower on T-Bills as compared to other market instruments.
Certificates of Deposit - They are very similar to fixed deposits. These term deposits are offered by the scheduled commercial banks. However, you cannot withdraw CD before the expiry of the term, unlike a fixed deposit.
Factors to check as an investor
- Liquid funds come with lowered risk but are not entirely risk-free. Risk is analysed on the basis of fluctuations in the Net Assets Value (NAV). Since the underlying assets in liquid funds mature within 60 to 91 days, the NAV does not fluctuate frequently. However, the value of the fund might drop suddenly on account of the downgrade of the credit rating of the underlying security.
- As per past evidence, liquid funds generate profits between 7% to 9% in contrast to 4% generated by a regular savings account. It must be noted that even though the returns are delivered positively, they are not guaranteed.
- Liquid funds are deemed to be ideal for investing cash surplus for a shorter horizon. This shall help the investor realise the full potential of the underlying securities.
- Liquid funds observe a hold till maturity strategy due to which they maintain a low expense ratio. The expense ratio has been mandated with an upper limit of 1.05% by SEBI. A low expense ratio ensures higher returns over a shorter period of time.
- Liquid funds are preferred if an individual wishes to create emergency funds since they come with a shorter holding period and offer higher returns.
- Liquid funds are an excellent medium to extract greater returns on investment as compared to a regular savings account. Liquid funds have a shorter holding period and the interest offered varies across different companies but is likely to lie between 7% to 9%.
It is very important to analyse your financial goals and risk appetite while choosing the market instrument for liquid funds. Even though mutual funds come with very low risk, they are not entirely risk-free.