What are Liquid Funds? How are They Taxed?

When it comes to investing in Mutual Funds (MFs), liquid funds are a popular choice, especially for those investors who want stability and liquidity in their investments. But what are liquid funds and how does their taxation work? This blog aims to explore liquid funds, making it simpler for investors to understand how they work and how they fit into a diversified investment portfolio.

Understanding Liquid Funds

Liquid funds are debt Mutual Funds. These funds invest in short-term market instruments like treasury bills, commercial papers and certificates of deposits. These instruments have a short maturity period i.e. not exceeding 91 days. This aligns with the norms set by the Securities and Exchange Board of India (SEBI) ensuring that liquid funds are a safe investment option.

Investing in such short-term instruments means that the market value of these funds remains more stable. Unlike long-term bonds, which experience significant price fluctuations with interest rate changes, the securities in liquid funds are less affected by these market shifts. This stability makes liquid funds an attractive option for investors seeking consistent returns without volatility.

Working of Liquid Funds

Before investing in liquid funds, it's essential to understand investment strategy and regulatory framework. Liquid funds focus on securities that are not just short-term but also of high credit quality and liquidity. This investment approach is supported by SEBI's guidelines, which include restrictions on the types of securities these funds can invest in and the sectors they can expose themselves to. For instance, liquid funds only invest in listed commercial papers with a cap on sector-wise exposure.

The regulatory framework established by SEBI plays an important role in maintaining the safety of liquid funds. It mandates that a minimum 20% of investment should be in liquid products like cash and money market securities. This offers significant peace of mind for investors, knowing that their investments are not only stable but also accessible.

Liquid funds earn through interest payments on their debt holdings. Since they invest in short-term securities, the impact of interest rate fluctuations on their market value is minimal, making them less prone to capital gains or losses. This feature is advantageous in a rising interest rate environment, where liquid funds often outperform other types of debt funds due to increasing interest earnings along with minimal capital losses.

Advantages of investing in Liquid Funds

Liquid funds offer several advantages making them an attractive option for a wide range of investors:

• Low risk: These funds are considered low-risk compared to other Mutual Funds, focusing on protecting the principal amount while providing steady returns. Their investment in short-term securities makes the fund's value stable, even in varying market conditions.

• Cost-effectiveness: Liquid funds are generally low-cost because they are not as actively managed as other Mutual Fund categories. Most liquid funds have expense ratios below 1% enabling investors to maximise their returns.

• Flexibility: Liquid funds have a flexible holding period. While there may be a small exit load for redemptions within seven days, investors enjoy the ease of entering and exiting, which is not always possible with other types of Mutual Funds.

Who should consider Liquid Funds?

Liquid funds are suitable for certain types of investors:

• Short-term investors: Those with an investment horizon of up to 3 months will find liquid funds to be an ideal choice. The maturity profile of the securities in which these funds invest aligns well with such short-term investment goals.

• Alternative to bank deposits: Investors who prefer bank deposits may find liquid funds a more flexible and potentially more lucrative option. Unlike Fixed Deposits (FDs), which have fixed tenures and in cases, penalise early withdrawals, liquid funds offer greater liquidity and often higher returns.

Important considerations before investing

Before investing in liquid funds, it is essential to consider a few key factors:

• Risk factors: Liquid funds are not completely risk-free. The returns on investment are subject to market conditions and unlike FDs, the returns are not always fixed.

• Alignment with financial goals: Investors must ensure that their financial goals and return expectations align with what liquid funds can offer. These funds are designed for safety and liquidity rather than high returns, making them more suitable for short-term financial needs or as a part of a larger, diversified investment strategy.

Taxation on Liquid Funds

Understanding the taxation rules for liquid funds is important as it will help investors to make informed decisions. The taxation of liquid funds is based on the duration for which they are held:

• Short-term Capital Gains (STCG): If the units of a liquid fund are sold or redeemed within 3 years, any gains are classified as short-term capital gains and are taxed according to the investor's income tax slab rate.

• Long-term Capital Gains (LTCG): If units are held for more than 3 years, then the gains are treated as long-term capital gains. Investors benefit from indexation, which adjusts the purchase price for inflation before calculating the capital gains. These gains are taxed at a rate of 20%.

How to select the best Liquid Fund?

When selecting a liquid fund, investors should consider several factors:

• Returns: Look at short-term returns (like one-month or three-month returns) to measure a fund's performance.

• Expense ratio: Since returns on liquid funds are almost similar, a lower expense ratio can result in higher net returns.

• Fund size: Larger funds are more stable and less affected by large redemptions.

• Portfolio diversification: A well-diversified portfolio minimises risk and ensures stability.

Liquid funds offer stability and flexibility. They are low-risk, making them an attractive option for a variety of investors. Whether it’s for short-term investment, an alternative to traditional bank deposits or as a part of a diversified investment strategy, liquid funds have a role to play. However, it is essential to align these funds with your financial goals and risk appetite. Understanding their taxation and selecting the right fund based on performance and cost can enhance your investment experience.