The debt fund category has evolved over the years, and is classified into several sub-categories based on their maturity period or the type of underlying security. Within this universe, liquid funds have for long been the short-term parking ground for corporates and HNIs for the liquidity they offer.
What are liquid funds?
Debt funds which only invest in securities with a residual maturity of not more than 91 days are liquid funds. Currently, the average portfolio maturity of funds in this category ranges between three and 52 days. Investments are mostly in money market instruments, short-term corporate deposits and treasury bills.
Why invest in liquid funds?
Liquid funds help you earn higher returns than a regular savings bank account or short-term fixed deposit, with a negligible risk and without compromising on liquidity. Redemptions from liquid funds are usually credited to your bank account in one working day. Some funds also offer instant redemption upto a maximum of Rs 50,000 or 90 per cent of your investment value, whichever is lower.
While liquidity is one factor that makes these funds attractive, their relative safety makes them the preferred parking option for HNIs and corporates or even retail investors to park their emergency corpus or a huge sum of money. Compared to other debt funds, these funds are relatively less sensitive to interest rate fluctuations because of their mandate to invest in securities with a maturity period of up to 91 days. Though credit risk prevails, there have been only rare instances of defaults in this category as these funds usually invest in instruments of high credit quality.
How are they taxed?
The returns from liquid funds are treated as capital gains and taxed only when they are realised. If you sell your investment in liquid funds within three years, the gains are added to your income and taxed at the applicable slab rate. If you sell them after 3 years, the gains are taxed at 20 per cent after providing for the indexation benefit.
For investments made up to the last financial year, dividends, if opted for, were tax-free in the hands of the investor. However, they were subject to Dividend Distribution Tax (DDT) of 29.12 per cent which was indirectly charged to the investor - it used to be deducted from the declared dividend before being passed on to the investor. However, ever since April 1, 2020, there is no longer any DDT, but dividends are added to an investor's income and taxed at the applicable slab rate.
To conclude, liquid funds are a good alternative to savings accounts or bank deposits as they offer superior returns while being liquid. Investors looking to explore this asset class can view a complete list of liquid funds here.