Liquid Funds: How safe is your liquid fund?

Mumbai, July 29, 2020

Are liquid funds safe now? The current COVID-19 crisis and the economic impact of the pandemic have thrown up several pertinent questions for investors with regard to their financial planning. Experts feel that these funds which are ideally tailored for meeting goals in the short-term, should steer clear of piling on excessive risks linked to liquidity or credit alike.

From an ideal perspective, it can be said that liquid funds do not have liquidity or credit risks. While this holds true most of the time, there have been instances where funds have not lived up to this premise in the full spirit of things. As a result, this has sometimes led to monetary losses where debt funds did not ensure investor payouts whenever required. However, the majority of funds in this category are still the best options for parking emergency funds.

Understanding how to invest in liquid funds

If you are thinking of investing in liquid funds in India, be assured that they have short-lived levels of volatility since regulations necessitate them to hold onto papers with maturities up to 91 days. Hence, investors who are careful to choose high credit quality based funds with large AUMs (assets under management) and lower modified durations, should select the best liquid funds which back their needs for an emergency corpus. This support should be there for more than 1 month, particularly if the investor falls in a higher tax slab, since the emergency corpus in question, may be held for a longer duration than previously estimated.

These are basically debt funds that make investments in fixed-interest instruments in the money market with shorter terms and 91-day maturity periods. There was a single instance sometime earlier, when these funds offered negative returns for some days owing to money market stress. However, the RBI (Reserve Bank of India) stepped in with its liquidity infusion for easing out the pressure. This was an exceptional scenario seen only during the 2008 global financial debacle. Hence, liquid funds will always be preferred instruments for parking funds for emergency purposes. Take into account the long-term performance of the fund and hold onto them for as long as you can.

What you should do in the current scenario

When it comes to the safety aspect, well, they are usually safer than many other market instruments. The liquidity levels remain high for your emergency funds while the returns are superior to those offered by your savings bank account. Keep holding onto funds in the current scenario in order to tide over temporary market crises. The security held in the liquid fund should be suitable for purchases whenever the manager of the fund wishes to liquidate the funds to repay the investor. Poor-quality credit will make it hard to find buyers when you need immediate liquidity. Make sure that you keep this aspect in mind before everything else.

What you should do is first estimate the size of the corpus for emergencies as per your own requirements and overall suitability. Divide this into several parts instead of taking it as one lump sum amount. You may have expenditure for about 10-15 days held in the form of cash for the household. This will help you overcome scenarios where you do not have sufficient access to ATMs, net banking or other digital transaction channels. Keep 15-20 days worth of expenditure in your bank account with the sweep (two-way) feature for shifting excess balance over a specified minimum threshold into an FD (fixed deposit) or even vice versa. The balance amount that remains should be deployed for liquid funds.

Risks that people end up taking

Many a time, people pile on excessive risks while investing in liquid funds which are not at all something desirable. They wish to earn higher returns or yields from their investment and are often drawn to the promise of the same. Investors often succumb to the temptation of drawing considerably higher returns and park contingency funds or money meant for taking care of necessary expenditure into certain funds for meeting short-term objectives. When the market is going fine, things will naturally remain positive for the investor and his/her financial planning.

However, a single company default will lead to a major downfall for the investment instantaneously. This happens due to negative market sentiments which impact almost everyone. Such a scenario was observed during the IL&FS market crisis, creating a scenario where even a smaller credit market segment may create an atmosphere of panic all around. Smart investors and fund managers are always clear about the fact that there is a cap on returns from these debt funds. Hence, it is futile to go after absurd returns while ignoring risks pertaining to credit. This strategy is faulty and may lead to losing the principal invested amount altogether as well. Taking risks which are disproportionate, in a bid to earn higher yields, is simply not the way to go about these investments. Make sure that investments are made in a liquid fund that aims at lowering credit or default risks and even risks to liquidity, i.e. inability to sell/liquidate assets for meeting redemptions. The goal should be investments in safe market instruments with higher liquidity levels.

The core take-away

When it comes to investing, avoiding risks is the best possible strategy you can adopt especially if you are a risk averse investor. So yes, liquid funds in India are comparatively safer than many other market instruments and are a great choice for parking emergency funds. However, you should make sure that risks are avoided as much as possible.

Choose funds that invest in treasury bills, government securities and even securities issued by PSUs (public sector undertakings) with AAA ratings for instance. There should be lower volatility and almost negligible chances of credit risks and capital losses. Liquidity levels should definitely be on the higher side.

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