Liquid Funds V/s Short-Term Deposits: Which is Better?

The primary reasons that have weighed on the performance of Liquid Funds (and Overnight Funds) are:

• Surplus liquidity in the system with a series of conventional and unconventional measures, taken by the Reserve Bank of India (RBI). In the current fiscal year 2021-22 as well, the RBI, drawing on its experience, has decided to put in place a secondary market G-sec acquisition programme or G-SAP 1.0. This will facilitate the central bank to commit upfront to a specific amount of open market purchases of government securities to enable a stable and orderly evolution of the yield curve amidst comfortable liquidity conditions. Similarly, it also plans to continue to deploy its regular operations under the Liquidity Adjustment Facility (LAF), longer-term repo/reverse repo auctions, forex operations and open market operations including special Open Market Operations (OMOs) to ensure that liquidity conditions evolve in consonance with the stance of its monetary policy and financial conditions.

• The RBI has resisted increasing the policy rates further; instead maintained a status quo even though retail inflation pressures (as measured by the Consumer Price Index) loom --CPI inflation averaged 6.2% in FY21. To shield the economy from the ill effects of the ongoing pandemic, the RBI is maintaining an accommodative monetary policy stance to support growth on a durable basis.

• Non-food bank credit growth has dropped (to 5.6% in FY21 from 6.1% in the previous financial year) owing to risk aversion amidst the pandemic. Plus, there are asset-liability mismatches on banks' balance sheets. These are also the primary drivers of short term interest rates.

• Bond yields have hardened, despite the RBI assuring that ample liquidity will be maintained to ensure that the government-borrowing programme moves smoothly. The rise in bond yield has negatively impacted bond investors.

Similarly, those parking money in bank deposits have been impacted. The interest rate offered to keep money into the saving account by some of the major banks in India is lower than the reverse repo rate. And speaking of the 1-year bank term deposits, the returns fetched are lower than the average retail inflation rate.

With retail inflation moving up on account of supply-side pressures in the domestic economy currently, plus 'imported inflation' inflicting a risk, it has become a rather tricky situation for conservative investors, as the returns clocked on bank fixed deposits and some debt mutual funds are proving inefficient when adjusted for inflation.

Even when it comes to parking money for contingency funds and short-term needs, investors expect that these avenues at least keep up with the pace of inflation so that the purchasing power of money is not eroded.

To catch up with inflation and make better returns, going by the AMFI data, it appears that Arbitrage Funds are seeing a lot of investors. The volatility in the Indian equity markets amidst the COVID-19 pandemic has enabled Arbitrage Funds to clock better returns than Liquid Funds for investors.

However, it is important to understand that arbitrage opportunities (due to mispricing in the spot and futures market) aren't available every time, and thus returns generated may not be attractive always. Under less volatile market conditions, when there are not enough arbitrage opportunities, an Arbitrage Fund could clock lower returns.

Thus, do not treat Liquid Funds, Overnight Funds and Arbitrage Funds at par with each other. The regulatory definition makes it mandatory for an Arbitrage Fund to follow the arbitrage strategy and invest a minimum of 65% of its total assets in equity & equity related instruments, and therefore for taxation purpose is treated as an equity scheme. Note that although the returns may be slightly better in certain market conditions at times and carry low risk, it is important to keep a comparatively longer investment horizon (around 2 to 3 years) when you approach an Arbitrage Fund.

A Liquid Fund and Overnight Fund, on other hand, are debt mutual fund schemes that essentially invest in money market and debt instruments with 1 day to up to 91 days maturity. So, you may consider them to deploy money for the short-term -- for a few weeks, months, to up to a year.

For illustration purpose only
(Source: PersonalFN Research)

That being said, select a Liquid Fund carefully. The IL&FS default episode, where investors lost 0.5% to 8% in Liquid Funds, since they had to mark down the company along with its group companies owing to sudden rating downgrades, is a lesson for every investor to remember.

Following this episode, the capital market regulator has imposed stricter rules for Liquid Funds that require them to hold at least 20% of their net assets in liquid assets such as cash, government securities, T-bills, etc. Furthermore, Liquid Funds and Overnight Funds aren't allowed to invest in debt papers having Structured Obligations (SO) and Credit Enhancements (CE) rating. These regulatory changes have made in the interest of investors.

(Image source: freepik.com; photo created by freepik)

Nevertheless, when you invest in a Liquid Fund ask these crucial questions:

• Is the quality of the securities held in the portfolio reliable?

• How reliable are the ratings assigned?

• What if the rating assigned to particular debt paper slips; does the fund house have adequate risk management measures in place in such a case?

• Does the fund manager compromise on the 'liquidity' aspects?

As far as possible, opt for a pure Liquid Fund and/or Overnight Fund, wherein the fund manager does not engage in yield hunting to clock better returns. Prioritise safety and liquidity over returns, particularly when planning for contingency and short-term financial goals that are one or two years away. Keep in mind, a Liquid fund and/or Overnight Fund is supposed to be an alternative to parking money in a savings bank account or short-term deposit and not for clocking high returns.

Our friends at Quantum Mutual Fund have highlighted the secret behind their debt management strategy, which has helped them provide safety and liquidity to investors when it comes to investing in quantum funds. Don't Worry, Quantum Liquid Fund always aims for Safety and Liquidity.

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits, but choose the bank carefully.

Happy Investing!

Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter

Editor's Note: If you are looking for quality mutual fund schemes to add to your investment portfolio, I suggest you subscribe to PersonalFN's premium research service, FundSelect. Currently, with the subscription to FundSelect, you could also get Free Bonus access to PersonalFN's Debt Fund recommendation service DebtSelect.

Under DebtSelect, we give high weightage to schemes displaying worthy portfolio characteristics. We avoid debt mutual fund schemes that aim for higher yields by taking undue higher credit risk with substantial exposure in instruments issued by private issuers.

At PersonalFN we follow a comprehensive S.M.A.R.T Score Matrix, wherein we evaluate...

S - Systems and Processes

M - Market Cycle Performance

A - Asset Management Style

R - Risk-Reward Ratios

T - Performance Track Record

The stringent process has helped our valued mutual fund research subscribers to own some of the best mutual fund schemes in the investment portfolio with a commendable long-term performance track record.

This service is apt if you are looking for insightful guidance and recommendations on some worthy funds having high growth potential, in the years to come.

We will also help you choose some of the best Equity Linked Saving Schemes (ELSS) for your tax-saving with PersonalFN's premium research service, FundSelect.

PersonalFN's FundSelect service provides insightful and practical guidance on which mutual fund schemes to Buy, Hold, and Sell.

If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!

Join Now: PersonalFN is now on Telegram. Join FREE Today to get ‘Daily Wealth Letter’ and Exclusive Updates on Mutual Funds