What are Liquid Funds?

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A look at what is a liquid fund, how it works and associated risks.

TLDR Points

• A liquid fund is a lucrative option that is low-risk.
• It has a comparatively shorter term ranging from 30-91 days.
• Price variations are small over short-term investments, which improves your investment horizon.
• With zero lock-in period, banks or AMCs can process redemption requests faster.

Introduction

A liquid fund is a type of debt-oriented mutual fund that provides good returns with minimal risk compared to other investment alternatives. Investing in liquid funds is a smart financial choice. If you have excess cash, which you may not need in a few days or weeks, or three months, you can invest it in liquid funds to earn returns.

Alternatively, suppose you wish to invest a large sum in an equity fund, but want to stagger the investments over a period. In that case, you could put your money in a liquid fund and enrol in a Systematic Transfer Plan (STP), which allows you to invest a fixed sum from your liquid fund to an equity fund each month. The risk in it is minimal, though not wholly absent.

The return of a liquid mutual fund depends on the fund's securities market price, and it is usually around 6-7%. Since short‐term securities prices do not change as much as long-term bonds, the returns of liquid mutual funds are relatively more stable compared to other debt funds.

According to the Securities and Exchange Board of India (SEBI) norms, liquid mutual funds are only allowed to invest in debt and money market securities with maturities of up to 91 days. Commercial paper, treasury bills, certificates of deposit, etc. are excellent examples of short-term investment.

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How liquid funds work?

Like every other mutual fund scheme, liquid mutual funds invest in securities that have a market price. When the market price of these securities changes, the value of your investment will vary too. But a liquid mutual fund's value doesn't alter as much as other funds as they are short-term, and prices do not change as much during the short-term.

Consider it this way; if you are getting to know a person, a short interaction may not necessarily be sufficient to pick up all the subtle nuances of their character. It takes a long-term relationship to do that. Similarly, price alterations over the short term are not as much.

Also, as per rules laid down by the capital market regulator SEBI, if a security has a maturity period of fewer than 60 days, it need not be marked to market. This rule means the interest you earn through the tenure of a security will be divided equally for the number of days you hold the security. The security's price remains steady. Hence your liquid mutual fund's value movement is linear, like a uniform line going up.

Does this mean your liquid mutual funds are risk-free?

Liquid mutual funds can invest in scrips that mature up to 91 days. Therefore, if you invest in scrips with a maturity period between 60 and 91 days, it needs to be marked-to-market and the same depending on its credit rating. A credit rating is a direct representation of a company's track history of defaulting. If such an underlying company defaults on its interest or principal repayment, the scrip's credit rating drops, and so does its market price. If your liquid mutual fund has invested in such a security, its value falls as well. Typically, most debt funds invest in scrips with a maturity period of 15 to 59 days to curtail their risk. It is also wise to choose liquid investments with a good credit rating and a very low possibility of default.

Conclusion

Liquid funds are smart investments, with a higher return on investment and the ability to fulfil all your lifestyle aspirations. Currently, redemption requests in liquid mutual funds are processed within one working day, and they do not have a lock-in period. With the help of technology, liquid mutual funds will be equipped to provide returns in a matter of minutes.

Are you looking at short or medium-term mutual fund schemes? Download the DBS Bank app and start investing in minutes!

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