Liquid Funds: Safe to Invest or Not?

20 Dec 2019 Read 441 Views

In the realm of investments, there are various kinds of funds available for investment. One such fund is liquid funds. There are quite mixed reviews about them. Some claim that they're quite safe to invest in, while others want to stay away from them. 

But, what are liquid funds exactly? In this article, we'll be discussing just that, along with some terminologies and examples associated with them.

Let’s get started.

What are Liquid Funds?

Before we begin our odyssey to understand liquid funds, I want you to have a quick look at the glossary below as we’ll be using these terminologies in its definition.

Financial Instruments

A contract with some monetary value (cash worth) associated with them. Basically, official ownership of something like assets or capital, like bank F.D's

Liquidity

It measures the ease of conversion of assets into cash. Stocks and bonds are hence called liquid assets

Maturity

The lifespan of any financial instrument or transaction. After reaching maturity, they must be renewed or would be removed from existence.

Debt Fund

A pooling fund-like mutual funds, but with a difference that they invest in securities with a fixed interest rate

Now we can define liquid funds easily.

 Liquid funds are a category of debt funds. They invest your money on short-term financial instruments with a maturity of around 90 days. Financial instruments involved in these investments are treasury bills (a kind of loan from the government), commercial papers (loan issued by financial institutes without any collateral), bank fixed deposits and government securities.

As a shareholder in a liquid fund investment, you can sell your shares anytime you want, i.e., there's no prescribed lock-in period in liquid funds. Furthermore, you can easily ask for repayment of your investment before maturity (also known as redemption), and the money transfer is done to your account. Hence, liquid funds don’t have any extra load (an amount you pay when you leave a fund scheme), nor do they have any entry load associated with them.

What does all this information tell you about liquid funds? If you guessed liquidity, then you're absolutely correct! All these factors add up to provide easy convertibility into cash to our investment, hence the reason these are called "liquid funds."

Now, let’s see how liquid funds work.

How do liquid funds operate?

In the above section, we've discussed the liquidity feature of liquid funds. But funds are also prone to drastic changes in interest rates. To overcome this problem, fund investors invest in what is known as debt instruments. Note that debt instruments are just a type of financial instrument.

Debt instruments provide capital for liquid funds, and in return, they ask for repayment of the capital according to a contract. Examples of debt instruments are loans, credit cards, bonds, etc. Fund managers investors always seek for a quality debt instrument for investing their funds. Debt instruments are less susceptible to market fluctuations (have less volatility), and they provide regular interest on debt security along with principal amount at their maturity.

Apart from just making the funds more secure, debt instruments also result in a higher return for shareholders, as they have parallel maturity with a fund's portfolio.

Are liquid funds safe to invest in?

Liquid funds may seem to be safer invest in, but they are not entirely free of risk. Following are the reasons liquid funds can be considered unsafe for investment:

Uncalculated Credit Risk

Recently in 2017, Taurus Liquid Fund AMC crashed to 7% in a single day. Reason? India Rating & Research, a credit rating (payback ability of an institution) agency, downgraded the rating of Ballarpur Industries Limited that day. Ballarpur Industries is where Taurus AMC's debt investment was made and was rated A3 in credit rating.

An A3 rating means more credit risk. Despite these fund managers held 4.33% of this unhealthy company, and as a consequence, investors like us and various banks suffered a significant loss. This the major risk involved with liquid funds that no can see coming.

Not Suitable for Emergencies

Remember, I talked about something called redemption?  You must be thinking it's quite like a savings account, i.e., you get your money any time you want. However, it is not true. If ‘T’ is the day at which you asked for redemption, then it’ll take T+1 day to receive the amount in your account. This is certainly not safe if you have some emergency, and are in dire need of your funds.

Final Words

Liquid funds do have risks associated with them, like mutual funds. However, this does not mean you shouldn't even consider investing in them. Consider investing in AAA-rated liquid funds, they may be low rated; but they are safe as compared to other liquid funds. Always remember, there are pros and cons to everything. All you need to do is find a way to extract more pros out of them, rather than the cons.

About the Author: Uttam Bhadauriya | 7 Posts

Uttam is a graduate in Computer Science, and has a passion for writing content. He's written various captivating articles for his university magazine, covering topics from various fields such as Finance, Technology and Healthcare. Having qualified IIT-JAM, he shows extraordinary enthusiasm towards Pure Mathematics and its application in statistical surveying.

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