Why Liquid Funds are a Good Idea

With the demonetisation drive that took the country by storm, liquidity has seen a tremendous increase and while the drive did stir up the pot, it managed to bring a lot of the currency back into the banks. The demonetized currency has almost entirely (close to 95%) been deposited back into the accounts and the overall financial ecosystem is currently seeing a great degree of liquidity.

This feature has consequences that reach farther than the lines at the ATM. Banks are now flush with cash which has caused them to reduce interest rates. Borrowers with car loans or home loans can enjoy this brief respite but investors’ better start looking at other options rather than traditional fixed deposits. Lowered interest rates also imply that the bank pays lower rates for deposit amounts thus reducing the returns.

The reduction in rates are meant to deter people from further depositing cash into the system. Investors can still opt for time tested methods of deposits that are extremely safe but give poor yields. Other options investors could consider are Liquid Funds.

Features of Liquid Funds

Liquid funds are money market funds that fall under the debt fund category. These funds give better returns than bank deposits and consist of investments such as short-term treasury bills, commercial papers, term deposits and certificate of deposits. The maturity period of assets invested in have an average period of 91 days

Liquid funds are offered by a wide range of fund houses. Entry or Exit loads are not imposed on these funds. Unlike equity funds, the management fees levied on liquid funds are lower as well ranging between 0.5% and 1%. Even the investment amounts are very affordable for those just starting off. Investments can be made through lump sums or through SIPs used in a manner similar to mutual funds. Lump sums invested in liquid funds can be as low as Rs.5,000.

Tax benefits

This is the realm in which liquid funds are far superior. Bank deposits usually offer lower interest rates but come with no risk. The interest rates on deposits can range from 4% to 7% and when you take tax deductions into account, the returns are further diminished. For those investors falling under the 30% tax bracket and holding a fixed deposit that offers an interest rate of 6.5% per annum, the interest rates received after tax deduction will wilt down to 4.55%

Liquid funds on an average have been earning more than bank deposits with interest rates averaging out at 8% to 9% per annum. This trend has been consistent over the past few years and even with a slump in interest rates of liquid funds as was witnessed last year, the funds still earned a rate of 7.5% which is comparatively higher than rates offered on bank deposits.

Another tax benefit of liquid funds is that the tax paid on annual interest rates does not occur annually as is the case with bank deposits. The tax is paid only when the fund is liquidated. Tax paid on returns is of two types. One is short-term capital gain tax which is levied on redemption of debt funds in less than 3 years or less than one year for equities. The second is long-term capital gain tax which is levied on redemptions made on debt funds after a period of three years.