Liquid mutual funds occupy an unusual position in personal finance. They generate less excitement than equity funds, lack the guaranteed returns of fixed deposits, and don’t benefit from the tax advantages of certain government schemes. Yet they solve specific financial planning problems that other instruments cannot address efficiently.
What Liquid Funds Actually Do
A liquid fund is a debt mutual fund that invests exclusively in short-term debt securities with maturities up to 91 days. The fund earns returns primarily through interest income, not through market price movements of the underlying securities.
Typical holdings include Treasury Bills, Government Securities, Commercial Papers issued by corporations, Certificates of Deposit from banks, and short-term corporate bonds. The fund’s NAV increases each day slightly as interest accrues on these holdings, even on weekends and holidays when markets are closed.
This daily accrual mechanism differs from fixed deposits, where interest compounds quarterly or annually. In liquid funds, your investment grows every single day based on the interest earned by the underlying securities.
The short maturity profile keeps price volatility minimal. Since securities mature within 91 days, changes in interest rates have a limited impact on the fund’s value. This makes liquid funds among the lowest-risk mutual fund categories.
Liquid Fund has three primary use cases:
Building an Emergency Fund
An emergency corpus requires two characteristics: immediate accessibility and capital preservation. Liquid funds deliver both more effectively than most alternatives.
The standard recommendation suggests maintaining 6-9 months of essential expenses as an emergency fund. For a household with ₹50,000 monthly essential expenses, this translates to ₹3-4.5 lakh.
A practical allocation strategy involves splitting this corpus: 60-70% in liquid funds and 30-40% in savings accounts or bank fixed deposits.
For a ₹5 lakh emergency corpus, this means ₹3 lakh distributed across two liquid funds from different AMCs with ₹1.5 lakh in each, and ₹2 lakh kept in a savings account or FD.
This structure provides ₹1 lakh in instantly accessible funds through the ₹50,000 instant redemption limit from each fund, plus the ₹2 lakh in the savings account. For larger emergencies requiring the full corpus, the remaining ₹2 lakh from liquid funds arrives within 1-2 business days.
The diversification across two AMCs reduces dependency on a single fund house’s systems and provides backup if one fund faces temporary redemption delays.
Short-Term Goals Under Three Years
Goals with timelines under three years cannot afford equity market volatility. A market correction six months before you need the money can derail the entire plan.
Liquid funds work for goals with high certainty of achievement: a planned home down payment in 18 months, a car purchase in two years, or funding a wedding in 30 months. These are discretionary goals where you control the timing and have committed to the expense.
The returns from liquid funds won’t dramatically accelerate goal achievement. They typically deliver 1% above the prevailing repo rate, currently around 6 to 6.5%. The value lies in preserving capital while generating returns modestly ahead of inflation, which savings accounts cannot consistently deliver.
Parking Surplus Cash Temporarily
Liquid funds serve as a holding area for money awaiting deployment. This includes annual bonuses, proceeds from asset sales, profits booked from equity investments, or any windfall requiring a decision on final allocation.
Many investors default to keeping such amounts in savings accounts, earning 3-4% while deciding what to do. Liquid funds generate 6 to 6.5% during this period with identical liquidity for amounts up to ₹50,000 per fund and minimal delay for larger sums.
Systematic Transfer Plans leverage this by parking lump sums in liquid funds and transferring fixed amounts monthly into equity funds. For example, placing ₹10 lakh in a liquid fund and setting up a ₹1 lakh monthly STP into an equity fund provides rupee cost averaging while the remaining amount earns returns instead of sitting idle.
How Redemption Actually Works
Instant Redemption Up to ₹50,000
For amounts up to ₹50,000, liquid funds offer true instant redemption 24 hours a day, 365 days a year, including weekends and holidays. The money arrives via IMPS within minutes.
A redemption request on Saturday afternoon reaches your account the same day. A Sunday evening request processes immediately. This feature operates outside market hours and banking holidays.
However, instant redemption requires investing directly with the AMC or in Statement of Account mode. It does not work for units held in demat form. Check your investment mode before assuming instant access.
Regular Redemption Above ₹50,000
Amounts exceeding ₹50,000 follow standard mutual fund settlement cycles. Redemption requests on business days settle on T+1, meaning funds arrive the next business day.
Weekend requests are treated as Monday submissions because mutual fund transactions are processed only on business days. A Saturday request receives funds on Tuesday, a three-day wait. A Sunday request also receives funds on Tuesday, a two-day wait.
To ensure the Monday arrival of funds, submit redemption requests by Friday before 3 PM. This matters when planning large expenses requiring amounts above ₹50,000.
Tax Treatment Compared to Fixed Deposits
Liquid funds provide tax deferral advantages over fixed deposits, though not necessarily lower tax rates.
In fixed deposits, interest income faces Tax Deducted at Source annually, even if you don’t withdraw the interest. Your capital compounds on post-tax amounts. For someone in the 30% tax bracket, a 7% FD effectively compounds at 4.9% after annual tax deduction.
In liquid funds, no tax applies until redemption. Your entire capital compounds at the pre-tax rate. Tax liability arises only when you redeem, and you pay based on your income tax slab at that time.
Both short-term and long-term capital gains from liquid funds are taxed at your income slab rate, matching FD taxation. The benefit lies purely in deferral, allowing compounding on the full amount rather than post-tax amounts.
For investors in lower tax brackets or those planning redemptions in years with reduced income, this deferral can produce meaningful differences over multi-year periods.
Understanding Risk in Liquid Funds
Liquid funds are generally low-risk but not zero-risk. Risk emerges when fund managers chase higher yields by compromising credit quality.
If most liquid funds yield 6.5% and one fund consistently delivers 7.5%, investigate why. Higher yields usually mean the fund holds lower-rated commercial papers or corporate bonds rated AA+ or A2 instead of AAA and A1+ rated securities.
One default in a lower-rated security can eliminate months of extra yield. A fund holding commercial paper that defaults on repayment sees its NAV drop immediately. Recovering that principal takes months or years through legal processes.
A reasonable benchmark suggests liquid fund yields should stay within 1% of the repo rate. Currently, with the repo rate around 6.5%, liquid funds yielding 6.5-7.5% operate within safe parameters. Anything significantly higher warrants caution.
Always prioritise credit quality over marginal return differences. Liquid funds exist for capital preservation and liquidity, not return maximisation. Chasing an extra 50 basis points by accepting credit risk defeats their purpose.
Selecting Liquid Funds
When choosing liquid funds, focus on these parameters:
Conclusion
Understanding what liquid funds do well and what they don’t do determines whether they belong in your financial plan. For most investors with emergency funds, short-term goals, or periodic surplus cash, liquid funds deserve a role. For others, different instruments may serve better.
Finology is a SEBI-registered investment advisor firm with registration number: INA000012218.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.