Why is Liquid Fund no longer a preferred alternative to FDs?

By: |
April 14, 2021 7:28 PM

From around 7 per cent annual return (CAGR) about a year ago, the returns on Liquid Fund schemes have fallen to below 4 per cent.

mutual fund, MF, Liquid Funds, fixed deposit, FD, FD rate, RBI, repo rate, reverse repo rate, retail investors, annual return, CAGRLiquid Funds used to provide returns comparable to bank FDs with better liquidity and indexation benefits on long-term capital gain.

Liquid Fund was earlier a preferred Mutual Fund (MF) category to park short-term money as such funds used to provide returns comparable to bank FDs with better liquidity and indexation benefits on long-term capital gain.

“Liquid funds are a specialised form of mutual funds that invest in extremely short term fixed instruments with a maturity of 91 days. These funds are ideal for corporates, institutional investors and business houses that park large sums for a very short period,” said S Ravi, former Chairman of Bombay Stock Exchange (BSE) and Founder and Managing Partner, Ravi Rajan & Co.

However, from around 7 per cent annual return (CAGR) about a year ago, the returns on Liquid Fund schemes have fallen to below 4 per cent, thus forcing retail investors to shift to other categories of funds.

But why have the returns (CAGR) on Liquid Funds dropped?

“The returns from liquid funds have dropped as the Reserve Bank of India (RBI) has gradually reduced interest rates over the last few years – from 6.5 per cent in January 2019 to 4 per cent in May 2020. Several unprecedented measures by RBI to increase liquidity (read as to make money easily available for banks to lend) during the pandemic have led to liquid fund yields and returns dropping much below the repo rate close to the reverse repo rate at 3.35 per cent as liquidity continues to remain in excess,” said Arun Kumar, Head of Research, FundsIndia.

Apart from the RBI’s stance to inject liquidity to revive the economy, Ravi also cites the risks that Liquid Funds face recently.

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“Default risk and interest risk have dented returns of liquid funds, Despite knowing the credit history of the Yes Bank, DHFL, etc some fund houses took a chance, impacting the credit ratings which has led to a decline in the NAV as well,” said Ravi.

“Further, the virtual forms of credit extensions have had a carryover effect on other banks’ credit ratings, thus making liquid and debt funds riskier and in some cases a loss-making instrument,” he added.

With returns dwindling below 4 per cent, only corporates and other investors – for whom liquidity is more important than return – now park their money in Liquid Funds.

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