Liquid funds

Savings accounts provide us with an interest of 3.5%, but offer liquidity, ie money can be availed ‘on demand’. Unfortunately, for most of the working population, especially the ones with high savings rate tend to accumulate this money in the savings account, resulting in higher CASA ratio for the banks (44.7% in case of ICICI). This interest rate fails to cover the ongoing inflation, so if one needs liquidity, they must lose money.

I came across an alternative to bank savings accounts. Liquid funds offer the liquidity, with slightly higher returns.  Going by the definition, liquid funds are mutual funds that invest in short term debt instruments issued by Government of India, or short term debt of companies with high credit rating. These funds are tracked against CRISIL liquid fund index.

What are the funds available in the market?

The funds available in the market include LIC MF Liquid fund, SBI magnum cash-liquid fund, IDFC savings advantage fund etc. for a complete list, check the following link (click on liquid funds button)

http://www.moneycontrol.com/mutualfundindia/

Rate of return

The rate of return for a typical liquid fund is 5.0 – 6.5%. This is a significant improvement from the measly 3.5% we get from savings accounts. The minimum investment is Rs 10000 onwards and the lock in period is 7-10 days. In the absence of entry and exit loads beyond the lock in period, these funds offer good opportunity to put the capital in (comparatively) safe instruments.

But there is a caveat: there is a short term capital gains tax @ 15% for investments of tenure less than 1 year. Long term capital gains, as with securities is 0. But whoever wants to park their money in liquid fund over the long period isn’t exactly doing justification to their money.

Comparison with savings account

I did a small comparison of liquid fund vis-à-vis savings accounts, and found the following.

Lets assume one has an investible surplus of 2.5 lakh, to be parked waiting for the equities to cool down.

Heading Savings a/c Liquid fund
Rate 3.50% 5.50%
Investment INR 250,000 250,000
Duration (days) 30 30
Interest INR 729.17 1145.83
Tax rate 20% 15%
Tax INR 145.83 171.88
Net interest INR 583.33 973.96

Assumptions: 30 days duration, marginal income tax rate of 20%

Impact of liquid funds on banks

One of the key parameters of bank performance is the CASA ratio. It shows the ratio of funds from current and savings accounts wrt total funds. The idea is that in case of CASA, the cost of funds is lower, and hence higher CASA ratio means the bank performs better.

It is evident that in the absence of financial knowhow, a lot of money lies with savings accounts of individuals. If more people channel their money towards liquid funds, banks could start worrying.

Impact of liquid funds on individuals

Overall, it looks like a good opportunity for individuals who hold demat accounts. All transactions can be made online, with minimum cost. STT and transaction costs are also evidently absent in such cases.

Needless to say, individuals being unaware of various nuances of finance are left confused between greed and fear. The liquid funds find favour with HNIs, who know money better.

Risks

AS with any financial instrument, even this has some risk associated with it. For instance, if a fund invests in short term debt of companies, failure on the part of the company to refund the debt will result in the NAV falling. But which is why credit rating agencies are present. Compare this with savings accounts, who says banks cant fail?

Tax implications

As much as my understanding goes, the only foreseeable tax implication is the short term capital gains tax. But it is a small price to pay for the seemingly larger return these funds provide.

References:

http://www.moneylife.in/article/81/5780.html

http://www.iloveindia.com/finance/encyclopedia/liquidfunds.html

http://www.sbimf.com/Product_Details.asp?ProductId=29

 

 

 

 

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