Liquid Funds: Safe to Invest or Not?

In the realm of investments, there are various kinds of funds available for investment. One such fund is liquid funds. There are pretty 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, 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 FDs.
• 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 let’s define liquid funds.

Liquid funds are a category of debt funds. They invest your money in 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 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. That’s 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 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 and 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 similar maturity with a fund's portfolio.

Are liquid funds safe to invest in?

Liquid funds may seem safer to invest in, but they are not entirely free of risk. Following are the reasons you should be careful about while investing in liquid funds:

Uncalculated Credit Risk

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 and banks suffered a significant loss. This is the significant risk involved with liquid funds that no one can see coming.

Not Suitable for Emergencies

Remember, we talked about something called ‘redemption’? You must be thinking it's pretty like a savings account, i.e., you get your money any time you want. However, it is not true. If ‘T’ is the day you asked for redemption, it’ll take T+1 days 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 compared to other liquid funds.

Always remember, there are pros and cons to everything. All you need to do is be watchful & find a way to extract more pros out of them, rather than the cons.

Invest wisely!