In the diverse landscape of personal finance instruments, liquid mutual funds often occupy a quiet corner. They rarely generate the buzz of equity funds, cannot promise the guaranteed returns of fixed deposits, and do not carry the tax benefits of specific government schemes. However, these funds excel at solving particular financial planning challenges that other tools cannot manage as efficiently.
What Are Liquid Funds and How Do They Work?
A liquid fund is a specific type of debt mutual fund that invests exclusively in short-term debt instruments with maturities of up to 91 days. The fund's returns are generated primarily from the interest income on these securities, not from trading or market price movements.
The portfolio typically includes instruments like Treasury Bills (T-Bills), Government Securities, Commercial Papers from corporations, Certificates of Deposit from banks, and short-term corporate bonds. A key feature is that the fund's Net Asset Value (NAV) increases slightly each day as interest accrues on these holdings. This accrual happens even on weekends and public holidays when the financial markets are closed.
This mechanism of daily growth is different from a fixed deposit, where interest compounds quarterly or annually. In a liquid fund, your investment grows every single day based on the earned interest. Furthermore, the short maturity profile of the underlying securities ensures minimal price volatility. Since the holdings mature within 91 days, fluctuations in broader interest rates have a very limited impact on the fund's overall value, making it one of the lowest-risk categories within mutual funds.
Primary Use Cases for Liquid Funds
1. Building a Robust Emergency Fund
An effective emergency corpus requires two critical characteristics: immediate accessibility and capital preservation. Liquid funds deliver on both fronts more effectively than many alternatives.
Financial planners commonly recommend maintaining an emergency fund equivalent to 6-9 months of essential living expenses. For a household with monthly essential expenses of ₹50,000, this translates to a corpus of ₹3 to ₹4.5 lakh.
A practical strategy involves splitting this amount: allocate 60-70% into liquid funds and keep 30-40% in a savings account or bank fixed deposit. For instance, with a ₹5 lakh emergency corpus, you could invest ₹3 lakh across two different liquid funds from separate Asset Management Companies (AMCs), with ₹1.5 lakh in each. The remaining ₹2 lakh stays in a savings account.
This structure provides ₹1 lakh in instantly accessible funds, leveraging the ₹50,000 instant redemption limit from each liquid fund, plus the ₹2 lakh in the bank. For larger emergencies requiring the full amount, the remaining ₹2 lakh from the liquid funds can be accessed within 1-2 business days. Diversifying across two AMCs also reduces dependency on a single fund house's systems.
2. Funding Short-Term Goals (Under Three Years)
Financial goals with a timeline of less than three years cannot afford the volatility of equity markets. A market correction occurring just months before you need the money can completely derail your plan.
Liquid funds are ideal for high-certainty, discretionary goals where you control the timing. Examples include a planned home down payment in 18 months, a car purchase in two years, or funding a wedding in 30 months.
While the returns from liquid funds—typically around 1% above the prevailing repo rate, currently in the range of 6 to 6.5%—won't dramatically accelerate goal achievement, their value lies in capital preservation. They generate returns modestly ahead of inflation, which regular savings accounts often fail to deliver consistently.
3. Parking Surplus Cash Temporarily
Liquid funds act as an excellent holding area for money awaiting final deployment. This includes annual bonuses, proceeds from property or asset sales, profits booked from equity investments, or any financial windfall.
Many investors default to keeping such sums in savings accounts, earning only 3-4% interest while deciding. Parking it in a liquid fund can yield 6 to 6.5% during the same period, with identical liquidity for amounts up to ₹50,000 per fund.
This utility is also leveraged through Systematic Transfer Plans (STPs). A lump sum can be parked in a liquid fund, from which a fixed amount is transferred monthly into equity funds. For example, placing ₹10 lakh in a liquid fund and setting up a ₹1 lakh monthly STP provides the benefit of rupee cost averaging in equities, while the idle balance continues to earn returns.
Understanding Redemption and Taxation
For amounts up to ₹50,000, most liquid funds offer true instant redemption 24/7, including weekends and holidays, with funds arriving via IMPS within minutes. This feature requires investing directly with the AMC or in Statement of Account mode; it does not work for units held in a demat account.
For redemptions above ₹50,000, the standard T+1 settlement cycle applies. Requests placed on a business day are settled the next business day. Requests on weekends are treated as Monday submissions, with funds arriving on Tuesday.
Regarding taxation, liquid funds provide a significant advantage through tax deferral. In a fixed deposit, tax is deducted at source (TDS) on interest annually, meaning your capital compounds on a post-tax amount. For someone in the 30% tax bracket, a 7% FD effectively compounds at just 4.9% after annual tax.
In a liquid fund, no tax applies until you redeem. Your entire capital compounds at the pre-tax rate. Upon redemption, the gains are added to your income and taxed at your applicable slab rate. While the final tax rate may match that of an FD, the benefit of deferral allows for more powerful compounding on the full amount over time.
Recognizing and Managing Risks
While low-risk, liquid funds are not zero-risk. The primary risk emerges when fund managers chase higher yields by compromising on the credit quality of the underlying securities.
If most liquid funds are yielding 6.5% and one fund consistently shows 7.5%, it warrants investigation. The higher yield often indicates holdings in lower-rated commercial papers or bonds (rated AA+ or A2 instead of top-rated AAA and A1+ securities). A single default in such a security can wipe out months of extra yield and lead to a sudden drop in NAV.
A reasonable safety benchmark is that liquid fund yields should generally stay within 1% of the prevailing repo rate. Currently, with the repo rate around 6.5%, funds yielding 6.5-7.5% operate within safe parameters. Always prioritise credit quality over marginal return differences. The core purpose of a liquid fund is capital preservation and liquidity, not return maximisation.
In conclusion, understanding the specific strengths of liquid funds determines their place in your financial plan. For investors building emergency reserves, saving for near-term goals, or managing periodic surplus cash, they deserve a dedicated role. For other objectives, different financial instruments may be more appropriate.
