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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. Evaluating the risk and returns of liquid funds
  4. What to consider or strategies for managing inflation risk in liquid funds
  5. Understanding the benefits of liquid mutual funds for retail investors
  6. Exploring the returns potential of liquid funds for retail investors
  7. Optimizing Returns with Liquid Funds: Strategies for Varying Market Conditions

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.

Evaluating the risk and returns of liquid funds

Just like any other investment option, liquid mutual fund investment also carries some degree of risk. Thus, a thorough evaluation of the credit quality of the underlying securities held by the fund and the interest rate sensitivity is highly advisable. Mentioned below are some additional factors you must consider when selecting liquid funds:

Factors to consider when selecting liquid funds

  • Portfolio quality: Evaluate the credit quality of the underlying securities held by the fund to gauge its risk level.
  • Fund manager’s expertise: Consider the experience and expertise of the fund manager in navigating various market cycles.
  • Fund size and liquidity: A well-sized fund with sufficient liquidity is crucial to ensure ease of entry and exit without impacting the fund's stability.
  • Taxation on gains: Liquid funds are taxed as debt funds. Debt funds are subject to taxation based on the applicable slab rates. The previously available long-term capital gains (LTCG) tax benefits and indexation benefits on debt mutual funds is no longer be applicable post the recent amendment dated 1st April’23.

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.

Understanding the benefits of liquid mutual funds for retail investors

Let us take a deep dive into the benefits of liquid schemes for retail investors:

  • Liquidity: One of the key advantages of liquid mutual funds is their high level of liquidity. Unlike other mutual funds with longer lock-in periods, liquid funds allow investors to redeem their investment at any time, subject to exit load, often providing instant access to funds. This flexibility makes liquid funds suitable for short-term financial goals or emergency cash requirements.
  • Flexibility: Furthermore, liquid funds offer retail investors the ability to invest and withdraw in smaller amounts, allowing them to customize their investment as per their financial needs. This feature is particularly beneficial for individuals who have limited surplus funds available for investment and prefer to invest gradually over time.
  • Limited impact on Capital: Risk mitigation is a crucial consideration for retail investors, and liquid funds can be beneficial in this aspect. Liquid funds primarily invest in low-risk, short-term debt instruments with high credit ratings. The focus on limited impact on capital ensures that the funds are less exposed to market fluctuations and volatility compared to other types of mutual funds. Additionally, liquid funds employ a robust risk management framework, including diversification and regular portfolio monitoring, to minimize potential risks. This provides retail investors with a sense of relative stability, knowing that their investments are relatively more stable and less prone to drastic value fluctuations.

Exploring the returns potential of liquid funds for retail investors

While limited impact on capital and liquidity are paramount for retail investors, the returns potential of liquid funds also deserves attention. It is important to note that liquid funds aim to generate a modest yet relatively stable return, as opposed to the potentially higher returns associated with equity or other high-risk funds.
Liquid funds generally tend to offer relatively better return potential compared to traditional savings accounts or fixed deposits. However, the returns from liquid funds are not fixed and subject to market movement unlike savings account or fixed deposits. Also, since liquid funds invest predominantly in highly rated money market instruments, they are a relatively stable investment option. Lastly, you can redeem your units of Bajaj Finserv Liquid Fund at any time with T+1 settlement timeline and plan your liabilities.

Optimizing Returns with Liquid Funds: Strategies for Varying Market Conditions

Let's dive into the strategies for navigating different market scenarios with liquid funds.

Strategies for volatile market

A volatile market calls for careful considerations in any investors’ portfolio and here are some key points to strategize in such a situation -

Prioritise liquidity: Choose highly liquid funds with daily redemption options to respond quickly to changing market conditions.

Maintain flexibility: Consider investing in a mix of short-term and ultra-short-term funds to balance relative stability with the potential for better returns.

Monitor closely: Adjust your investment strategy as needed. Regular portfolio reviews are crucial in volatile times.

Strategies for stable market

In a stable market, one should look at following these strategies to optimise the return potential with liquid funds -

Seek yield enhancement: Explore liquid funds with exposure to high-quality corporate bonds for potentially higher returns than traditional banking products.

Don't over-chase returns: Remember, liquid funds are primarily for relative stability and liquidity. Don't compromise stability for marginal gains.

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.

What factors contribute to the return potential of liquid mutual funds?

The return potential of liquid funds is influenced by several factors such as prevailing interest rates, fund managers expertise and any associated fees or expense. Investors should evaluate these factors before investing in liquid mutual funds.

Are liquid mutual funds suitable for all investors?

The return potential of liquid funds is influenced by several factors such as prevailing interest rates, fund managers expertise and any associated fees or expense. Investors should evaluate these factors before investing in liquid mutual funds.

How do liquid funds differ from other mutual funds?

Investment duration and risk profile are the factors that differentiate liquid mutual funds from most other type of mutual funds. Liquid funds focus on short term and highly liquid assets while most other types of mutual funds invest in a wide range of securities with varying risk profiles.

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.

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