The one-year return of liquid funds, on an average, is not even 3%. This is pathetic. It makes sense to put money here for very short periods of time. But does it make sense to invest in it when it comes to my Emergency Fund, or should I stick to a bank fixed deposit?
This question was presented to us by a reader. Before we directly address that issue, it is worth noting what investments must be part of an Emergency Fund.
When it comes to an Emergency Fund, the focus is safety and liquidity. It is not a tool to create wealth. Hence, returns take a back seat.
What must comprise an Emergency Fund portfolio are various types of debt instruments. However, no instrument with a lock-in period, such as the Public Provident Fund, or PPF, can be part of an this corpus. It is foolish to have equity investments as part of an Emergency Fund since the volatility of the asset will defeat the basic purpose of capital preservation and liquidity. One may need the money during the depths of a bear market, and would be forced to sell investments at a huge loss.
Now let’s attempt to answer the query.
Why the returns have not been impressive.
The slowdown in the economy got exacerbated by the pandemic and the consequent lockdowns. Since 2019, the Reserve Bank of India has cut the policy rate sharply (250 bps) and announced a slew of measures to support the economy.
The fall in interest rates along with abundant liquidity in the banking system resulted in yields falling across the yield curve, particularly at the shorter end. This sharp fall is also reflected in the yield to maturity (YTM) of funds across the shorter duration spectrum. This is the reason liquid funds have delivered low returns over the past year.
Banks too have cut down on both savings and fixed deposit (FD) rates offered to investors, owing to surplus liquidity amid low credit off-take and access to low-cost funding from the central bank.
The other costs.
Pre-mature withdrawals in case of bank fixed deposits are charged a penalty on the interest earned. Liquid funds are charged miniscule exit loads on the invested amount for redemptions only within the first six days.
If your investment in a liquid fund (like other debt mutual funds) is held for more than three years, on redemption, tax is levied on long-term capital gains (LTCG). The amount is 20% post indexation. If the investment is held for up to three years, then short-term capital gains (STCG) taxation is applicable. Here the gain is added to the overall income and taxed according to the tax slab of the investor.
Interest received on fixed deposits is taxed each year at the marginal tax rate. What this means is that the interest earned is added to the overall income, and taxed according to the tax slab of the investor.
But do remember that in the case of bank fixed deposits and savings accounts, the interest earned up to Rs 10,000 per annum is tax deductible under section 80TTA (Rs 50,000 in case of senior citizens under section 80TTB).
Making a choice.
Liquid and Overnight funds meet the prime requirements of safety and liquidity. Both are open-ended debt fund categories that invest in high credit quality instruments entailing minimal credit and duration risk.
Both types of funds have portfolios diversified across high credit quality instruments with minimal duration risk. They are typically accessible within T+1 days (T being date of redemption).
Overnight funds invest in securities that mature in one day; reverse repo, TREPs and other debt instruments that mature in one business day. On the other hand, liquid funds can invest in securities maturing in up to 91 days, such as T-bills, commercial paper, certificates of deposits, repos and instruments. The average maturity of liquid funds being around 1-2 months.
Banks fixed deposits are not market-related investments like the above, but are guaranteed return instruments. You know exactly what you are going to get at the time of investment, and for what period.
Given the very short tenor of the underlying instruments, the YTMs of these funds closely track interest rates in the money market as the maturity proceeds of underlying instruments are rolled over and invested at the prevailing market rate. Currently, the yields are low due to low short-term borrowing costs amid surplus liquidity conditions. As the economy picks up steam, interest rates are likely to move upwards and so will the YTMs offered by such funds.
What is yield?
In conclusion.
Given that interest rates offered on very short tenor deposits (<6 months) are somewhat comparable to YTMs on liquid funds, investors deciding between liquid funds and bank FDs should consider their liquidity needs, investment horizon and applicable taxation.
Our suggestion would be to have an Emergency Fund that has a mix of all these investments, such as a bank fixed deposit and a liquid fund. It need not be one to the exclusion of the other.
Do read, Do you need debt funds in a portfolio?
