Liquid fund returns: Understanding the inflation risk

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Liquid funds are gaining popularity among investors, for their convenience, relative stability and better return potential than traditional savings bank accounts. But what happens to these funds in a high inflation environment?

This article will discuss liquid fund returns in inflation challenges and the strategies investors can explore to manage liquid fund investment returns in inflation risk.

  • Table of contents
  1. Understanding returns in liquid funds
  2. Inflation risk in liquid funds
  3. What to consider or strategies for managing inflation risk in liquid funds
  4. FAQs

Understanding returns in liquid funds

Liquid funds are open-ended debt mutual funds that invest in debt and money market instruments with high liquidity and maturity of upto 91 days. Examples of these instruments include treasury bills, commercial papers and certificates of deposit.

Liquid funds are relatively low risk because of the short maturity of their underlying debt instruments. The return potential in liquid funds comes primarily from interest earned on the underlying securities. Such funds have historically tended to offer higher returns potential than most savings accounts.

However, returns are not guaranteed and can vary depending on economic conditions.

Inflation risk in liquid funds

One of the potential risks with liquid funds is that their returns may not always keep pace with inflation, especially in a high inflation environment. Inflation is the increase in the cost of goods and services over time and erodes the purchasing power of money. If liquid fund returns are outpaced by inflation, then the effective value of these returns reduces. For example, if the inflation rate is 7% but the post-tax return from liquid funds is only 6%, then the investor in real terms is effectively making a negative return. Their money is losing value instead of gaining it.

What to consider or strategies for managing inflation risk in liquid funds

Given this risk, investors need to factor in inflation while setting return expectations from liquid funds. Some strategies to help manage inflation risk include the below.

  • Select liquid funds that actively manage credit risk to optimise the return potential during inflationary periods.
  • Diversify into instruments like inflation indexed bonds and floating rate bonds.
  • For long term goals, consider allocating some funds to equity mutual funds which have historically delivered inflation-beating returns over 7-10 years.
  • Build an emergency corpus that covers 6-12 months of essential expenses, so you don't have to withdraw invested capital during unforeseen circumstances.
  • Revisit investment goals in line with expected inflation and modify allocations accordingly to maintain purchasing power.
  • Keep track of moving inflation numbers and interest rate cycles to take tactical calls.

Conclusion
While liquid funds are a relatively low risk short-term investment option, their returns may fall short of inflation during high inflationary periods. Investors need to factor in inflation realistically while setting return expectations.

Diversifying investment portfolios, actively selecting funds and reviewing goals periodically can help manage inflation risk to some extent in liquid fund investments over the long run.

Bajaj Finserv Liquid Fund invests predominantly in highly rated money market instruments with up to 91 days residual maturity. Its objectives are to provide a level of income consistent with preservation of capital, lower risk and high liquidity. However, there is no assurance that the objective of the scheme will be achieved.

FAQs

How does inflation affect the overall performance of liquid funds?
The nominal returns generated by liquid funds may fail to preserve an investor's purchasing power in a high inflation scenario. The longer high inflation persists, greater the erosion of real returns for liquid fund investors. So, inflation is a significant challenge for liquid funds to cope with and deliver positive real returns.

How can investors mitigate inflation risk while investing in liquid funds?
Investors can partially mitigate inflation risk associated with liquid funds by diversifying into other low-risk debt instruments. Liquid funds should only form a part of one's overall portfolio with investments also made in short duration bond funds with higher potential yields than liquid funds, inflation indexed bond funds and floating rate funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.