Rising interest rate trend has made liquid funds attractive: Experts

Investors entering the market now can expect above 5% return at low risk, better than parking money into a savings bank account

While rising interest rates are a cause for concern for most debt fund categories, one that benefits from this phenomenon is liquid funds. The returns of this category have improved in the recent past and could get even better if interest rates continue to climb.

Invest in short-term instruments

Liquid funds invest in debt and money-market securities with maturity of up to 91 days. They are subject to graded exit load if the units are sold within seven days from the date of allotment. The introduction of overnight funds and imposition of exit loads on liquid funds by the Securities and Exchange Board of India has ensured that liquid funds don’t get hot money.

Improving YTMs

In 2020, when interest rates were being cut to combat the slowdown caused by Covid-19, returns from liquid funds had fallen very low. Since they invest in money-market instruments maturing in up to three months, their returns are typically close to the repo rate, or that of short-term money-market instruments like treasury bills. Over the past year, these funds have given a category average return of 3.6 per cent.

However, the category’s prospects have improved in 2022. The Reserve Bank of India (RBI) has so far hiked the repo rate by 140 basis points to 5.4 per cent. Yields of money-market instruments have also moved up.

The average yield to maturity (YTM) of liquid funds is currently 5.5 per cent. After factoring in an average expense ratio of 18 basis points (for direct plans), the net expected return works out to 5.32 per cent. 

“Liquid funds have finally started delivering returns above 5 per cent due to the repo rate hikes. Most liquid fund portfolios have maturity of 30 days, which means that on an average the entire portfolio gets aligned with prevailing interest rates every 30 days,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund.

He adds that liquid funds are well suited for parking surplus money if one doesn’t want to take any credit, duration, or spread risk.

Better than bank deposits

The returns from liquid funds, currently, look better than what savings accounts of leading banks are offering — around 3.5-4 per cent (some offer higher returns). Even one-year bank fixed deposits are offering around 5.5-5.75 per cent.

If the RBI hikes the repo rate further, the returns from liquid funds could get even better. “With the RBI expected to hike the repo rate in the future, investors should prefer liquid funds over savings accounts or very short-term bank deposits,” says Sanjiv Bajaj, joint chairman and managing director, Bajaj Capital.

Park your emergency funds

Since liquid funds are short-term investments with high liquidity and no lock-in (which fixed deposits have), they are suitable for parking one’s emergency corpus.

“The main aim of liquid funds is to provide high liquidity and safety to your capital. Ideally, you should opt for liquid funds if you are investing for a few weeks or months,” says Bajaj. 

Should you invest?

Liquid funds offer both low credit risk and low interest-rate risk. At a time when there is a possibility of recession in large parts of the developed world, and interest rates within India are on the upswing, investors must try to minimise either of these risks in a portion of their fixed-income portfolios.

At the same time, those opting for liquid funds should be aware of the risks they carry. These funds offer market-determined returns and the market can turn at any moment.

“If interest rates were to come down, portfolios of funds holding longer-maturity bonds would generate significantly higher returns. Being overinvested in liquid funds could lead to opportunity loss,” says Bagla.  

Investors should, therefore, use liquid funds sparingly to keep their short-term, idle money.