Liquid funds, which are essential debt funds that invest in short‐term assets, have become popular as they offer benefits like quick maturity, low cost and no lock-in period. This category of funds is most suited for those who have idle cash and are looking for a way to earn slightly higher returns on this cash, rather than leave it in the savings account.
Here’s a look at what impacts the returns on liquid funds and what you can do about it.
When Do Liquid Funds Generate Low Returns?
RBI Repo-Rate Cuts
The returns generated on liquid funds are dependent on the RBI repo rate. The repo rate is the rate of interest at which the Reserve Bank of India (RBI) lends money to commercial banks or other financial institutions whenever they need it. If the RBI increases the repo rates, the rate of interest on investments also increases. On the other hand, if the RBI slashes interest rates, the same will happen with the rate of interest on investments.
At the start of the pandemic in 2020, the central bank brought down the repo rate to support the economy. The Reserve Bank of India, in its Monetary Policy Statement in May 2020, announced to reduce the repo rate to 4% from 4.40%. Although the move benefited borrowers, it resulted in lower returns for investors. This is when liquid funds generated lower returns. However, subsequently, the RBI has been raising interest rates.
Regulations to Increase Security of Funds
In 2019, SEBI issued a circular to better manage risks with liquid funds. Under this circular, SEBI stated that all liquid funds will need to invest 20% of the total assets invested in highly liquid securities to ensure sufficient liquidity at all times. These securities include cash equivalents, G-Secs and Treasury Bills. These securities are the least risky, but also generate the least returns. Investing 20% of the assets in these securities ultimately reduces the total returns.
What Should You Do?
It can be confusing when liquid funds are not generating enough returns. The best idea is to look for an alternate investment option like mutual funds or liquid MF.
Investors who are risk sensitive can include liquid mutual funds in their investment portfolio. As you diversify your portfolio with mutual funds, you also diversify risks. You can choose to invest with a lumpsum payment or in small amounts every month via what is called a Systematic Investment Plan (SIP). You can start investing in MFs with as low as Rs.100 per month and can benefit from rupee cost averaging. After maturity, you can either withdraw the complete amount at once or choose Systematic Withdrawal Plans (SWP), where you benefit by withdrawing small amounts each month. When the money is invested for a longer period, the returns are typically higher than the short-term liquid fund returns.
With you invest for a longer period, you also benefit from the power of compounding. Investing in mutual funds through SIP also helps you develop the habit of saving every month.
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