Liquid funds are high liquidity income schemes that primarily allocate money in money market instruments and debt mutual funds. Some of the underlying securities in the portfolio of a liquid fund include treasury bills, government securities, and call money, among others.
Until 2019, the returns from liquid funds were somewhere around 6-7%, which was better than the 3-4% returns an investor can earn by parking their money in a savings bank account. The risk attached with liquid funds is also low. Thus, SIP in liquid funds is the smartest way to fulfill short-term goals like a family vacation.
However, since 2020, the performance of liquid mutual funds has dropped. The average return from the funds in the entire year was 4.16%. The performance was low even in 2021. Consequently, investors are worried and wondering what they should do.
For better understanding, let us understand the reasons behind the low returns generated by liquid funds.
Why are liquid funds delivering low returns?
- RBI rate cuts
The Reserve Bank of India (RBI) regulates repo and reverse repo rates periodically depending on the existing economic landscape. Repo rate refers to the rate at which commercial banks can take a loan from the central bank. These rates are also referred to as benchmark rates. After the pandemic and the resultant lockdown, the country witnessed an economic slowdown. There was a sincere need to cut down the repo rate. So, the RBI reduced the repo rate by 40 bps in May 2020. Therefore, within one year, the repo rate fell from 6% to 4%.
Liquid funds allocate money in instruments like government securities and T-Bills. With the falling repo rate, the returns of these instruments have declined. In some instances, the return has fallen even below RBI’s repo rate of 4%.
- Changing risk profile of liquid funds
A SEBI circular was issued in September 2019. Its goal was to enhance the risk management framework for the category of liquid funds. As per the circular’s mandate, liquid funds must invest a minimum of 20% of net assets in liquid assets. The purpose of this announcement was to ensure adequate liquidity at all times if the redemption requests increased.
Liquid assets are treasury bills, G-Secs, and cash and cash equivalents. Before September 2019, SEBI had not made any such investment mandate. Thus, liquid funds could invest in liquid securities. As of May 2019, the average holding of liquid funds in liquid assets was 10%. These securities have the lowest risk and offer lower returns. After SEBI’s mandate, liquid funds needed to allocate 20% of their assets in low-return securities. This modified allocation led to a drop in the returns of liquid funds.
Conclusion
You can invest your idle money in liquid funds if you have short-term goals. They help you earn better inflation-adjusted returns. Liquid funds are also a good option for investors who want to build contingency funds. Currently, the returns may be low, but they will reverse as soon the RBI increases the repo rate. The Tata Capital Moneyfy App gives you valuable information to start investing in mutual funds.