Liquid Funds vs FD
If you want to park surplus cash, the battle is usually between :
Liquid fund Vs FD.
Traditionally, people have mostly opted for Fixed Deposits (FD)
There are 2 Good reasons for that :
- Perceived Safety
- Lack of alternative options
We believed for a long time (and for good reason) that Government = Safety.
That made sense.
In the past, the business environment was not as developed as it is today and the Government had to step in to ‘ensure trust’ in the banking system.
Government banks still account for more than 65% of the Total Loans in the system.
And in the absence of better alternatives, no wonder FD has been the preferred choice of most people.
But the same way Private Banks have become more acceptable, liquid funds too have become a great alternative to fixed deposits.
What are Liquid Funds?
Liquid funds are mutual funds that invest in Fixed Income Securities.
Most companies need cash for working capital & other business needs.
When these requirements are for periods upto 91 days, they issue ‘papers’, which is basically a promise to pay back the money Principal + Interest back.
Liquid funds take money from Investors like Yourself and I, and invest in these papers.
Companies get their money needs met and investors (You and I) get to earn a slightly higher return than Bank FD.
Here are the 5 reasons why Liquid Funds can be superior to Fixed Deposits.
Fixed Deposits are not a bad option, however, Liquid funds offer advantages in terms of slightly higher return, Risk Management and lower taxation.
Q. How do Liquid Funds manage their Risk?
Q. What if Bonds in a liquid fund default (i.e – The borrowing company can’t pay back the loan)?
Most Retail Investors would avoid Liquid funds only and only because they can’t answer What the risk is and what causes the risk?
That’s understandable because if you can’t answer the two questions above you can’t manage the risk.
Firstly, Liquid funds are riskier than FD’s.
However, that’s not a bad thing at all.
Riskier doesn’t always mean – You will lose all your money.
Most of us still feel way more comfortable and confident driving on the road than flying in an aeroplane.
So, there are risks involved in most things we do. However, we get habituated to taking those risks and therefore perceive them to be ‘less risky’.
Then, there are those risks that are are actually not as risky as you think but there is emotional resistance to taking these risks because :
- You don’t really understand what the risk is and what causes the risk
- You have never taken the risk before
Investing in Liquid funds is one such risk.
So, what’s the risk, what causes it and how can we manage it effectively?
Like I mentioned earlier, Liquid funds invest in fixed income securities (Loans) issued by generally large companies.
Let’s take a look at one such Liquid fund.
Source : www.valueresearchonline.com
As you can see in the section named ‘Top Holdings’, loans are given to reliable names such as RBI, Indusind Bank, Jio, NTPC etc.
This is not always the case.
And this is where the risk comes in.
There are 2 types of Risks involved :
Risk of Default
If a liquid funds invests in companies that can’t pay them money back, then investors lose money. Think : IL & FS and DHFL.
How Liquid Funds tackle this risk?
There are 2 ways Liquid funds manage this risk :
- Invest ONLY in the highest rated companies’ loans (Debt Instruments)
- Buy a large number of loans so that even if a few default, your capital is not impacted
Therefore, your priority should always be to choose funds that have a high number of ‘loans’ (Diversified) in its portfolio and its top assets should consist of the heavy weights such as RBI, Reliance or other blue chips. Please note we don’t mean to say ALL blue chips are investment worthy but most are.
According to us, you should not chase high returns when it comes to Liquid funds.
Interest Rate Sensitivity Risk
Interest rates directly impact the returns you can earn from Liquid funds.
Because Interest rates can vary from time to time (RBI meets bi-monthyl to review Interest rates & Monetary policy), liquid fund returns can vary accordingly.
In a falling Interest Rate environment (such as the one we are in right now), FD will tend to give a higher return because you can basically lock in a rate for the period of the FD.
In a rising Interest rate environment, Liquid funds will tend to have a higher return.
So why don’t we simply pick liquid funds or FDs according to where the interest rates are going?
If only we knew whether Interest rates will go up or down from here.
And because Interest rates are unpredictable for the most part, there is no point trying to use this factor to choose an FD or Liquid fund.
Liquid funds by nature are not affected much by Interest rates because of the short duration of the debt instruments they hold.
Interest Rate sensitivity risk is as close to zero as it can get for Liquid Funds.
Therefore, while most investors think that Liquid funds are ‘riskier’, if chosen correctly liquid funds offer significant tax advantages, can manage risk effectively, and offer a higher rate of return.
To learn more about How you can SAVE TAX with Liquid Funds, check out our article : Liquid Fund Taxation – The Complete Guide.
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- The writer works with Mr. Varun Malhotra and EIFS.
- EIFS is an education company. We are not an advisory and therefore, no statements made in the article above or on this website in any form should be construed as investment advice. please consult your financial advisor before making any financial decisions.