Liquid funds, which were, of late, losing their sheen, are back in focus again.
This is thanks to the RBI’s hike in reverse repo rate in its recent April policy that has led to a notable increase in short-term money market rates. The overnight call rate and yield on 3-month T-bill rate have gone up by 30-40 basis points since April.
Liquid funds invest in money market instruments such as call money, CBLO, and treasury bills. These funds are likely to gain from the recent increase in rates, as they earn returns through accrual. Birla Sun Life Floating Rate Fund - Short Term Plan, which has delivered category-beating returns across time periods, is a good option for those looking for alternatives to bank savings and fixed deposits. Over one, three and five years, the fund has delivered 7-8.6 per cent annualised return.
Why nowLiquid funds, on an average, have delivered nearly 8 per cent returns annually over a longer time period of three to five years. But the returns generated by these funds fell over the past year to 7-odd per cent.
The RBI moving to neutral from a deficit liquidity scenario in April last year and excess liquidity, post demonetisation, led to a fall in short-term rates; the call rate had slipped below the repo rate before the April policy.
The RBI’s hike in reverse repo rate has aligned market rate to the repo rate (6.25 per cent). Liquid funds, which essentially earn return through accrual, have stood to gain.
While the recent fall in inflation has raised hopes of a rate cut by the RBI again, surplus liquidity in the system, the global situation and uncertainty around the long-term trend of inflation are likely to weigh on the RBI’s rate action. Moreover, liquid funds invest in debt securities with a residual maturity of less than or equal to 91 days. With the maturity period this short, both interest rate risk and credit risk (default risk) are minimal.
For investors looking to invest for less than three years, their returns will be taxed at the income tax slab rates. Interest on savings accounts is exempt up to ₹10,000 under Section 80TTA of the Income Tax Act. But even assuming 7-7.5 per cent return on liquid funds, post-tax returns work out higher than the 4 per cent that most banks offer.
Remember, however, that while liquid funds carry the lowest risk amongst debt funds, they are still riskier than bank deposits.
Fund portfolioThe fund (as of April 2017) holds 8.7 per cent in Certificate of Deposits (CDs), 52.8 per cent in commercial paper and 10.2 per cent in fixed deposit. The current yield to maturity is 6.7 per cent.
Top holdings of the fund include JSW Steel, Axis Bank, Kotak Mahindra Bank, India Infoline Finance and Indiabulls Real Estate.
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