Mutual Funds

Fund query: Where to park emergency funds

Aarati Krishnan | Updated on March 27, 2021

I am 33 years old and have been an avid reader of BusinessLine for a long time now. My questions are as follows: 1) Is it advisable to use debt schemes for parking my emergency funds? I already use savings accounts and fixed deposits. 2) If so, can you please tell me what percentage of the total emergency funds can be in debt schemes? 3) What will be the tax implications in terms of long- and short-term capital gains in doing this? 4) Can you please suggest some reliable debt funds for emergency fund investments?

Sridip Das

It is good that you’ve thought of building up an emergency fund before going on to other forms of investment. It would be ideal to have 9-12 months’ worth of living expenses in an emergency fund. While choosing avenues to park your emergency money, safety of your capital and the ability to quickly withdraw your money should score over other criteria such as returns and tax- efficiency. Given that we’re suggesting such a large emergency fund, we recommend that you divide it into three parts. A small portion of the emergency fund, say one month’s expense, can be kept in cash.

During natural calamities, such as the Chennai or Kerala floods, network issues made online transactions difficult and bank ATM networks were mostly non-operational. Having some hard cash stored safely at home can help you meet emergency living expenses during such times, without undue stress.

A second part of your emergency fund, say three months’ worth of living expenses, can be held in savings bank accounts and fixed deposits. Fixed deposits, however, need to be instantly redeemable online, with the proceeds getting credited into your savings account. Do make sure that your savings account and fixed deposits for parking this portion of your emergency funds are with a leading, systemically important bank with sound financials. Banks such as SBI and HDFC Bank best fit the bill. Do not worry too much about the low returns they offer as safety and liquidity are your primary considerations.

While liquid, ultra-short and other forms of debt funds were considered suitable options for parking emergency funds, recent episodes of such funds holding lower-rated corporate bonds and other risky instruments have underlined the risks that can be inherent in debt schemes even in these categories. Franklin Templeton’s abrupt shuttering of its six schemes, including its ultra-short and short-term debt fund — citing its inability to liquidate some of its bonds held in these schemes to meet redemption demands — has brought to light the fact that debt mutual funds aren’t the best options for your emergency money. Therefore, if you are a conservative investor who seeks only safety and real liquidity from your emergency funds, it is best that you stick to bank FDs and savings accounts for your entire emergency fund.

However, given that we are suggesting a sizeable emergency corpus, this will entail a loss in terms of returns and tax-efficiency. While overnight funds are the safest category of debt funds, investing mainly in Collateralised Borrowing and Lending Obligations (CBLOs), their returns can be lower than that of savings bank accounts and, therefore, make limited sense for retail investors. Liquid funds are your next best bet in terms of capital safety. However, as some liquid funds do invest in corporate commercial paper, it is necessary to choose your liquid funds carefully so that you only park your emergency funds in conservatively managed ones.

Look for liquid funds that invest mostly in CBLO, treasury bills and certificates of deposit with leading banks. Commercial papers, if any, must be from Central government-backed entities. Quantum Liquid Fund, ICICI Prudential Liquid Fund and Axis Liquid Fund are some options. Invest in the direct plans to save on costs and earn slightly better returns.

On tax-efficiency, debt mutual funds are more tax- efficient than bank deposits only when held for over three years. As dividend options of debt funds are subject to dividend distribution tax, only the growth options of debt funds make sense. When held for less than three years, the returns on growth options of debt funds are subject to short- term capital gains tax on your income-tax slab rates. Your bank fixed deposit interest is also taxed at the same rate. It is only when you hold debt funds for more than three years that their tax-efficiency kicks in, with long- term capital gains tax at 20 per cent with your costs adjusted for inflation indexation. However, when you hold debt funds for an emergency, a three-year holding period is not a given, so you cannot count on using these benefits. Savings bank interest of up to ₹10,000 a year is tax-free; you can look to optimise that.

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Published on March 27, 2021

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