scorecardresearchWhy you should choose liquid funds over bank deposits to park your idle

Why you should choose liquid funds over bank deposits to park your idle money

Updated: 09 Jan 2023, 08:01 AM IST

There is so much confusion over allocating money to savings deposits versus fixed deposits versus liquid funds. In most cases, ignorance about liquid funds forces investors to be content with bank deposits.

Liquid funds are better than bank deposits for myriad reasons.

Liquid funds are better than bank deposits for myriad reasons.

Many investors are complaining that the interest rate on savings account deposits has not gone up much despite banks and financial institutions announcing a hike in fixed and recurring deposit rates. The desire to have enough liquidity in hand prompts many investors to set aside their idle money in their savings accounts. Savings bank account interest is taxable as “Income from Other Sources”. Section 80TTA allows you to deduct up to 10,000. Following that, the interest will be added to your income and taxed at your marginal tax rate. 

Liquid funds, meanwhile, provide much higher yields on your idle funds while also providing high liquidity.

To start with, liquid funds are a category of debt mutual fund schemes that invest primarily in money market instruments with a residual maturity of less than or equal to 91 days, thus, providing investors with the opportunity to earn higher returns on very short-term deposits while maintaining adequate capital safety and liquidity. Also, liquid funds are ideal for investors with a short investment horizon. If you have a low-risk tolerance and want to earn higher returns than fixed deposits (FDs), you can invest in liquid funds.

Why invest in liquid funds?

While you are allocating some money to your emergency corpus set aside in bank deposits, it makes sense to park a part of it in 91-day treasury bills and certificates of deposit (CDs). The returns from them are much higher than what you earn on fixed and recurring deposits, thus, affirming their growing popularity. 

Liquid funds have high liquidity because they invest in papers that mature within three months. Because liquid funds invest in short-term instruments, their price sensitivity to interest rate changes is extremely low. Liquid funds, in other words, are not exposed to interest rate risk. 

In addition, SEBI has taken regulatory steps to reduce credit risk in liquid funds. It requires that 20 percent of the assets under management (AUM) of liquid funds be held in risk-free instruments such as government securities, treasury bills, TREPs, CBLOs, and cash. SEBI, among other papers, has established a 20 percent limit on exposure to single sectors. These steps lower the credit risk associated with liquid funds.

On business days, liquid fund redemptions are processed within 24 hours. Some asset management firms also provide instant redemption for liquid funds. The redemption proceeds for online instant redemption instructions are usually credited to your savings bank account within 30 - 45 minutes of receiving the redemption request. 

Also, these funds experience no significant losses because they invest in fixed-income securities with high credit ratings. To assess the risk associated with the underlying securities, check their credit ratings.

Investors should be aware that liquid funds charge an exit load for redemptions made within seven days of investing. You should make appropriate plans. 

Also, when you redeem your mutual fund units, you must pay tax on both short-term and long-term capital gains. Compared to them, fixed deposit interest is taxable and is subject to TDS deduction. If the interest earned on the fixed deposit exceeds Rs. 40,000, you must pay the tax deducted at source (TDS) at 10 percent (if you have provided your PAN card details) or 20 percent (if you have not provided your PAN card details). If you are a senior citizen, you will be charged 10 percent TDS if your FD returns exceed Rs. 50,000.

Should you invest in liquid funds?

You may want to know what kinds of investors would take interest in keeping their money in liquid funds. The first among them would be investors who want to keep their funds idle for a few weeks or months. Next come investors looking for high liquidity and capital safety. The third kind of people includes investors who want to invest in equity funds from liquid funds using the systematic transfer plan (STP). However, to check if liquid funds are appropriate for their short-term investment needs, investors must consult their mutual fund distributors.

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First Published: 09 Jan 2023, 08:01 AM IST