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Tax efficient liquid funds could prove to be more stable if the interest rates are raised

 

Liquid funds could prove to be a stable fixed- income asset class if the interest rates are raised again. With inflation still on the higher side — consumer price inflation for October stood at 11.24 percent — and economic conditions sluggish, with Index of Industrial Production lower at 1.8 per cent, the Reserve Bank of India at its next monetary policy meeting is quite likely to raise the repo rate by 25 basis points to eight per cent, from the present 7.75 per cent. Any rate increase would hit the debt market. Liquid funds, however, could prove to be a stable category in this current fluid environment, as liquidity has eased. These funds' net asset values are not impacted, as much of the rates are increased in the future. Returns too, are higher.

At this time, one of the great products to buy is a liquid fund, as it provides total flexibility to an investor. It also offers higher yields, which might not last and it probably has the best risk- reward ratio in the market. Both, interest rate risk and credit risk, are lower in this category of funds. One can reduce risk by buying more money market assets or by buying higher- rated bonds. This category of funds have the best of both for now.

On the other hand, the 10year g- sec yield crossed the nine per cent market more often in the past month, with a corresponding increase in risk levels of other debt fund categories. But, as liquid funds are largely buying debt paper that matures in a few days or weeks, risk is lower in this category.

Overnight money- market rates are hovering around eight per cent. The RBI would probably increase rates. So, in longer- term tenures, you could still see some pain, and hence it's better to have more exposure to liquid funds. You could choose between two types of money- market funds, liquid or ultra- short- term. As the names suggests, these invest in short- term corporate debt paper, certificates of deposits, commercial paper and government T- bills in order to generate higher returns on your investments and, at the same time, maintain high liquidity. Debt paper held by these funds usually mature within a month; sometimes, within a few days.

Average returns from liquid funds in the past one year have come at about 8.77 per cent, with many funds giving returns of little over nine per cent, according to data from Value Research. Average one- month returns have also been 0.77 per cent, which translates to 9.24 per cent per annum.

Besides, parking money in liquid funds is more tax efficient than putting your money in a savings bank account. In a growth option, these types of funds offer long- term capitalgains tax if held for over a year. In a dividend option, the fund has to deduct at source the dividend- distribution tax, though dividends are tax- free in the hands of an investor. In a one- year option, returns work out to twice as much as keeping money in asavings account. An investor would earn around 8.9 per cent (post- tax) if the investment were in the money- market fund (growth option), compared to 3.38 per cent in a one- year savings deposit, according to a report by Crisil study.

Parking money in liquid funds is more tax efficient than putting your money in asavings bank account. In a growth option, these types of funds offer long- term capital- gains tax if held for over a year

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