With bond yields expected to climb after the government’s greater capital spending target for FY23, investors wishing to increase their debt mutual fund allocation should stick to liquid funds. Bond rates and prices are inversely proportional; when yields rise, prices fall, and vice versa.
Mark-to-market losses in debt schemes, particularly those investing in longer-duration securities, occur when bond prices fall (yields rise). Liquid funds, which invest in shorter-term bonds, are the least harmed in such a scenario.
When it comes to mutual funds, savvy investors can find a wealth of information for the public to aid in their decision-making. There’s advice about when and how to invest, which plans to choose, how to choose funds, mutual fund risk, and much more.
Exit plans for mutual funds, on the other hand, are scarce, making this the most challenging task for investors. When markets decline, having conviction in an exit strategy becomes even more important; now, without, investors panic and quit based on emotion about a good strategy.
What are liquid funds?
Liquid funds are debt funds invested in short-term assets such as Treasury bills, government securities, repurchase agreements, certificates of deposit, and commercial paper. According to SEBI regulations, only debt and money market funds with maturities of up to 91 days are authorised to be purchased by liquid funds.
The return of a liquid fund is determined by the market price of the securities it owns. Liquid funds, on the other hand, have more stable returns than other debt funds since short-term securities do not vary as much as long-term bonds.
How do Liquid Funds work?
A liquid fund often invest in short-term, high-quality, and liquid equities. SEBI recently established a set of rules to enhance these fund characteristics.
Liquid funds can only invest in listed commercial paper, and their overall exposure to a sector is limited to 20 percent.
Liquid funds make most of its money from interest payments on the debt holdings, with capital profits accounting for only a tiny portion of the total revenue. This is the primary characteristic of liquid funds.
Advantages of Liquid Fund
- Liquid funds are low-cost debt funds because they aren’t as actively managed as other debt funds. Several liquid funds have expense ratios of less than 1 percent. This low-cost structure enables them to optimise the investor’s effective return.
- A liquid fund is a manageable debt investment that focuses on preserving principal and producing consistent returns. As a result, the worth of a liquid fund remains relatively constant during market interest rate cycles. Funds that hold longer-maturity assets, on the other hand, can see big capital profits when rates are falling and huge capital losses when rates have increased.
- A liquid fund investor can keep their money for as long as they want. Liquid funds feature flexible holding periods, despite a small exit load for redemption within 7 days. This allows you to easily enter and quit the investment while still generating safe, market-linked returns over time.
- Redemption requests are fulfilled within one business day, and some funds even provide rapid redemption. This is conceivable because liquid capital is invested in highly liquid securities with a low risk of default.
Final Thoughts
As an option for bank savings and short-term fixed deposits, liquid funds remain a solid option to play this impending interest rate tightening cycle.
Given the steep slopes of the yield curve, some government bond yield curve areas offer opportunities. If you have a longer time horizon, a combination of liquid funds and, for example, a dynamic bond may be preferable to lock in current rates in fixed deposits, as long as you progressively raise your allocation to dynamic or long-term bond funds as market yields climb in the following year.