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Liquid Fund Investments

The risk in these funds has largely been done away with

I would like to invest around Rs 10 lakh in a liquid fund for the short-term. Is this the right time to invest in this category? I am a little skeptical about the fiscal deficit, which will force the government to borrow from markets? What will be the effect of government borrowings on the returns of liquid funds? Suggest some good ones? Also, should I invest in the growth option or dividend option?
-    Vishal

Your doubts about interest rate volatility in the coming times are well-founded. As the government borrows and issues bonds, bond prices will drop while interest rates will rise. As a consequence of falling bond prices, debt funds will also lose.

However, as per new norms for liquid funds, they have to invest all their assets in instruments with a maturity of up to 91 days only. Due to this short maturity profile of liquid funds, the risk of uncertainty in interest rates gets ruled out to a large extent, making them much more stable as compared to debt funds. Also, debt securities with maturity of one year or less are valued on the basis of their yield-to-maturity (YTM), which means that intermediate changes in interest rates will not affect their valuations.

You may pick any of these funds: ICICI Prudential Liquid, HDFC Cash Management Savings and UTI Money Market. If you plan to use these funds within one year, go for the dividend option. Dividends will be subject to a dividend distribution tax at 28.33 per cent while the capital gains within one year will be taxable as per your tax slab.

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