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How to earn inflation-adjusted returns on my emergency funds without putting my capital at risk?

Going forward, there is a general expectation of an upward bias in bond yields, which should contribute towards improving the returns of liquid funds, says Ashutosh Gupta

How to earn inflation-adjusted returns on my emergency funds without putting my capital at risk?

I've been using FDs to hold my emergency funds. I'm evaluating the option of investing in liquid funds but in the current scenario, with low-interest rates, their yield is below inflation rates. Is there any option to earn at least inflation-adjusted returns without putting my capital at risk?
- Akshay Thakur

One is that you should always prioritise safety, liquidity and low volatility over returns as far as allocation for emergency needs is concerned. So, I'd say a bank account with a sweep-in facility where surpluses beyond a certain threshold automatically go to an FD can be a viable option. This is because there is no compromise on liquidity and withdrawals from such an account are pretty seamless. But remember, in the case of an FD, if you withdraw prematurely and break it, you have to incur a penalty and returns fall there as well. Also, if you continue to hold your emergency corpus and keep it invested for more than three years, which I hope happens to be the case with you, i.e., you don't land up in an emergency situation, then FDs tend to be less tax-efficient vis-à-vis debt mutual funds. In this case, investment in a debt mutual fund tends to contribute meaningfully because of relatively higher post-tax returns. More so for someone who is falling in the higher tax bracket.

Now coming to liquid funds, well yes, their returns have been fairly low in the recent times. Forget about inflation, they've barely been able to match up to the returns of savings bank accounts. And that is because interest rates have been fairly low, particularly towards the shorter end of maturity. But from here on, hopefully, the returns from liquid funds should improve and that's because since January, the bond yields have been on a rise. Now what happens in the case of liquid funds is that because they invest in bonds that are maturing in less than 90 days, their portfolios come up for redeployment pretty quickly. There is a pretty high churn in the portfolio. So currently, as their portfolios are coming up for redeployments, the reinvestment is happening at relatively higher yields and that should contribute to higher returns from these funds from here on. In fact, we can already see a slight uptick in the yield-to-maturity across several liquid funds. Now going forward, since the general expectation is that there will be an upward bias in yields of bonds, that should contribute towards improving the returns of liquid funds.

Having said that, it is still a far cry from the 6 per cent or higher returns that liquid funds used to generate till sometime back. So, from that perspective, one needs to keep one's return expectations a little moderate and that's the kind of returns one has to live with. At best, you can consider allocating some portion to an ultra-short duration fund which would be slightly more volatile but can generate slightly higher returns. But I would reiterate that you should not focus too much on returns for your emergency needs rather focus on safety and liquidity.

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