What Exactly are Liquid Mutual Funds? Should You Make an Investment?

Liquid mutual funds are a type of debt mutual fund scheme that invests in securities with a maturity period of up to 91 days. They are categorized as debt funds and primarily allocate their investments to debt and money market instruments such as bonds, debentures, Certificates of Deposit (CD), Commercial Papers (CP), and Treasury Bills (T-bills), among others.  

These funds are not linked to the market and have a short maturity period, which gives them high liquidity and the name "liquid mutual funds." Instead of keeping surplus money in a savings account or fixed deposits, liquid mutual funds are often considered an ideal option for parking such funds.  

Understanding Liquid mutual funds   

Liquid mutual funds, as a type of debt funds, invest in fixed-income securities with minimal risks. They invest in high-quality debt securities that have a residual maturity of only 91 days. During this short period, the Net Asset Value (NAV) of the fund units experiences minimal fluctuations since they are not linked to the market like equity funds. 

Although debt mutual funds are exposed to interest and credit risks, the chances of sudden changes in the interest rate or credit rating of the underlying securities are relatively low. These funds are aimed at providing investors with a high level of liquidity and are considered one of the safest mutual fund categories.  

Taxation of Liquid mutual funds   

Liquid mutual funds are taxed according to the rules applicable to debt funds. Liquid Fund returns are classified as short-term if the investment is held for less than 3 years. They are treated as long-term gains if held for more than three years. Short-term capital gains (STCG) are added to the investor's income and taxed according to their income slab. As per the Finance Bill 2023, long-term investments in debt mutual funds (where the equity element of the mutual fund scheme does not exceed 35%) made on or after April 1, 2023, shall be taxed at the appropriate income tax rates.  

Why Should You Invest in Liquid mutual funds?   

Experts often recommend allocating a portion of surplus income to liquid mutual funds due to their numerous benefits, as outlined below:  

1. Short Tenure   

Liquid mutual funds invest in short-term fixed-income instruments, making it convenient for investors to invest their money in these funds. Unlike equity funds, which are suitable for long-term investments, liquid mutual funds have a short-term maturity and serve as an excellent alternative to fixed deposits (FDs). They generally offer higher returns compared to FDs and provide greater liquidity. Experts often suggest building an emergency fund for unexpected life contingencies, and a liquid fund is an ideal choice for this purpose.  

2. Low Risk   

Debt funds, including liquid mutual funds, are considered low-risk investments because they are not linked to the market. However, they still carry interest rate risks. While debt funds can be riskier when held for an extended period, the 91-day maturity period of liquid mutual funds makes them one of the safest options for investors. Liquid mutual funds, due to their short-term underlying securities, have minimal risks. Additionally, they invest in highly rated money market instruments, further reducing the overall risk levels.  

3. No Lock-in Period