Liquid Funds – Make your cash work harder

“Where do you keep your cash?”

“Means?’

“Is there money with you, maybe in your bank, which want to keep for short term and not invest or lock in anywhere?”

“Oh yes!  There is usually some money there which I need for emergencies. It could also be a need for an immediate future expenditure. “

“OK. I am sure you are aware that money in the bank earns you interest at 4% per year.”

“Yes. I know that.”

“You also recognise that by leaving your money in the bank you are earning a negative return.”

“Sigh! I know what you are talking here. Inflation is higher than the return I am earning in my savings account. But what is the alternative? I can put that in a FD. Do you have any suggestions?”

“Yes. There is another alternative. Liquid Funds. Have you heard of them before?”

“No. But I guess it is a mutual fund scheme. Wouldn’t that be risky?”

“What do you mean by ‘risky’?”

“I mean mutual funds are meant for long term. I would need the money in very short term. Isn’t there a risk? What if I lost money?”

“Hmm. I guess you are referring to mutual funds which invest in equities. When we talk to liquid funds, we refer to debt funds.”

“Oh yes! There are debt funds too. I recall now. Why don’t you tell me more about these liquid funds?”

“Sure.

Liquid funds are debt funds that invest in very short term instruments. The residual maturity of such instruments is  maximum of 91 days. As you would understand that in debt investments, you get interest and your principal investment is returned.

Just that in debt funds, this is adjusted in its daily value also called the Net Asset Value.

They would subscribe to debt instruments of corporates, banks, even Treasury Bills of the Government. All these investments offer a return that is higher than a savings bank account.”

“I got it. Now if I want to invest in a liquid fund, how do I select the right one?”

“Now in debt funds, there are 2 things that determine their function – interest rate and credit quality of the investments.

Interest rates can move up or down and can impact the value of a debt fund. This is the risk here. Typically, when interest rates go up, the value of the fund goes down and vice versa.

Credit Quality helps you assess the default risk of an investment. The highest credit quality investment is unlikely to default on payment of interest or principal. As credit quality goes down, the risk of default increases.

To compensate for lower credit quality, the issuer of the instrument (call it the borrower) may offer you a slightly higher interest as a compensation for taking the higher risk.”

“Interesting!”

“Now coming back to liquid funds, since the residual maturity period of the investments they hold is maximum of 91 days, the chances that they would be impacted by any interest rate movement are very low. Not something to be really bothered about.

However, one has to keep in mind that the liquid fund being chosen is investing in short term instruments only. If it is not doing that and taking exposures to medium or long term investments, it should be given a miss.

After that, the only question that now remains is to see the credit quality. You should choose a liquid fund that has the highest credit quality (AAA) investments in its portfolio.”

“Where can I find this information?”

“Oh, you should look at the scheme fact sheets which are available on the respective websites of these funds. For an initial filtering you can use the various online mutual fund information websites too.

You can filter by category, which in this case would be Debt – Liquid. You will get to see detailed information about a fund along with comparisons with its peers.

Look at average maturity to check whether the fund has exposure to low or high maturity investments. In the detailed portfolio listing, you would see the credit quality rating for each of the instrument.”

The middle column in the above image shows the credit ratings and the last column shows the residual maturity (in days) of the instrument.

“OK. That’s great.” Pause.

“What is the typical return one can expect from a liquid fund?”

“The return from a liquid fund will depend upon a lot on the prevailing interest rates in the market. Just to give you a perspective, currently the returns have been averaging around 8% a year. This could go down if overall the interest rates go down in the economy and vice versa.”

“Yes, I understand that. Just one more thing. What would be the minimum investment I need to make in a liquid fund?”

“The minimum investment would vary across some funds but for the first time you would need to invest Rs. 5,000.”

“OK. Now, if I have to withdraw money, how much time does it take to receive money from a liquid fund?”

“That’s an important one. The whole idea of a liquid fund is to be able to access money when you want to. When you redeem money from a liquid fund, the money comes to your bank account the next day.

However, keep in mind the time limits for transactions. You would have to put your request before 3 pm on Day 1 to get the money in your registered bank account on Day 2.

In equity funds, in contrast, the money usually comes to you on Day 4.”

“Fantastic. Let me push my money lying idle in the bank into liquid funds today.”

“Just to add, you can keep most of your money that you would need on an emergency basis or for any short term needs into liquid funds. There’s no harm in getting an additional return with a negligible risk.”

“Yes, that makes complete sense.”