Unit 5: Liquid funds

1. Salient Features of Liquid Funds

Liquid funds are a specialized category of debt mutual funds designed primarily for capital protection and providing high liquidity. They invest in very short-term money market instruments.

• Restriction on Maturity: Under regulatory guidelines (such as SEBI in India), liquid funds are mandated to invest only in debt and money market instruments with a residual maturity of up to 91 days.
• Underlying Instruments: The portfolio predominantly consists of high-rating instruments such as Treasury Bills (T-Bills), Commercial Papers (CPs), Certificates of Deposit (CDs), and Tri-party Repos (TREPS) or Collateralized Borrowing and Lending Obligations (CBLOs).
• Minimal Interest Rate Risk: Because the instruments mature in a maximum of 91 days, the portfolio's sensitivity to macroeconomic interest rate changes is exceptionally low. This allows the fund to avoid capital depreciation during interest rate fluctuations.
• High Liquidity & Fast Settlement: Redemptions are typically processed on a T+1 basis (the next working day). An instant redemption facility is also available in many liquid funds, allowing investors to withdraw up to a certain limit within minutes.
• Graded Exit Load structure: To discourage very short-term parking of funds that disrupts fund management, a graded exit load is applied for withdrawals made within 7 days of investment. After the 7th day, the exit load is zero.
• Mark-to-Market Valuation: Securities in the portfolio are marked-to-market daily, ensuring transparent and fair reflection of the portfolio's value in the daily Net Asset Value (NAV).

2. Floating Rate Scheme

A floating rate fund is a debt mutual fund that invests primarily in financial instruments with variable or floating interest rates, rather than fixed interest rates.

• Mechanism: The interest rate on these bonds is reset periodically (e.g., daily, monthly, or quarterly) and is pegged to a specific financial benchmark, such as the Mumbai Interbank Offered Rate (MIBOR) or the Repo Rate.
• Objective: The primary goal of a floating rate scheme is to hedge against interest rate risk. In traditional fixed-asset debt funds, bond prices fall when interest rates rise. In a floating rate fund, as interest rates rise, the yield of the fund adjusts upwards symmetrically, protecting capital and increasing returns.
• Asset Allocation: Regulatory mandates usually require these funds to invest a minimum percentage (e.g., 65%) of their total assets in floating rate instruments.
• Synthetic Floating Exposure: If direct floating-rate bonds are unavailable or illiquid, fund managers use derivatives like Interest Rate Swaps (IRS). They buy fixed-rate bonds and enter a swap agreement to exchange fixed-rate cash flows for floating-rate cash flows, synthesizing a floating rate exposure.

3. Portfolio Churning of Liquid Funds

Portfolio churning refers to the buying and selling of securities within a fund's portfolio. In the context of liquid funds, churning behaves very differently than in equity funds.

• Passive vs. Active Churning: Unlike equity funds where the manager actively buys and sells to capture market upside, churning in liquid funds is mostly passive and systemic.
• High Maturity-Driven Turnover: Because the maximum maturity of any instrument is 91 days, securities are constantly maturing. The fund manager receives cash from these matured papers and must continually reinvest it into new papers. Therefore, a liquid fund naturally possesses an extraordinarily high portfolio turnover ratio.
• Impact on Returns: In equity funds, high churning leads to high transaction costs (brokerage, taxes), which erodes returns. However, in the wholesale debt market where liquid funds operate, transaction costs are negligible. The continuous reinvestment cycle allows the fund's Yield to Maturity (YTM) to closely track current prevailing money market rates.
• Credit Quality Maintenance: Churning also allows fund managers to quickly adjust the credit quality of the portfolio. If a corporate issuer's outlook deteriorates, the manager can simply let the 30-day or 60-day paper mature and decline to reinvest in that issuer.

4. Capital Gains Taxation

When an investor redeems their mutual fund units at a price higher than the purchase price, the profit is termed a capital gain. The taxation of these gains depends heavily on the holding period and prevailing tax laws.

• Holding Period Definitions (Traditional):
  • Short-Term Capital Gains (STCG): Traditionally, if debt fund units are held for less than 36 months, the gains are considered short-term.
  • Long-Term Capital Gains (LTCG): If held for more than 36 months, the gains are considered long-term.
• Traditional Tax Treatment:
  • STCG: Short-term gains are added to the investor's total income and taxed according to their applicable marginal income tax slab.
  • LTCG: Long-term gains were historically taxed at a flat rate (typically 20%) with the benefit of indexation, making them highly tax-efficient compared to fixed deposits.
• Crucial Regulatory Updates (e.g., India Finance Bill 2023): It is critical to note that tax codes evolve. For instance, in India, for investments made on or after April 1, 2023, into debt mutual funds (where domestic equity exposure is less than 35%), the LTCG and indexation benefits have been abolished. All gains, regardless of the holding period, are now treated as STCG and taxed at the investor's marginal tax slab rate.

5. Concept of Indexation

Indexation is a mathematical adjustment applied to the purchase price of an asset to account for the impact of inflation over the holding period.

• The Rationale: Inflation erodes the purchasing power of money. Consequently, a portion of the nominal profit generated by a long-term investment is merely compensating for inflation, not genuine wealth creation. Indexation prevents investors from being taxed on the "inflationary" part of their profit.
• Cost Inflation Index (CII): Tax authorities publish a standardized index (the CII) every financial year to track the general level of inflation.
• The Formula:
  Indexed Cost of Acquisition = Original Purchase Price × (CII of the year of Sale / CII of the year of Purchase)
• Impact on Taxation: By using the indexed cost of acquisition (which is higher than the original purchase price) instead of the actual purchase price, the taxable capital gain narrows significantly.
• Note on Relevance: As mentioned in the taxation section, while indexation remains a vital concept in taxation for assets like real estate or legacy debt investments, recent tax amendments have removed this benefit for new investments in pure debt and liquid funds in specific jurisdictions like India.

6. Fixed Maturity Plans (FMPs)

Fixed Maturity Plans are close-ended debt mutual funds with a predetermined maturity date, functioning similarly in concept to bank Fixed Deposits but operating through the capital markets.

• Hold-to-Maturity Strategy: The core philosophy of an FMP is that the fund manager raises capital during the New Fund Offer (NFO), and constructs a portfolio of debt securities whose maturity dates align perfectly (or are slightly shorter than) the maturity date of the FMP itself. The manager buys these instruments and holds them until they mature.
• Elimination of Interest Rate Risk: Because the instruments are held to maturity rather than traded on the open market, the investor is immunized against interest rate variations during the tenure of the fund. The yield is practically "locked in" at the time of investment.
• Liquidity: Being close-ended, investors cannot directly redeem units with the fund house before the maturity date. To provide a degree of liquidity, FMPs are mandatorily listed on stock exchanges. However, trading volumes are typically negligible, meaning they are practically illiquid until maturity.
• Credit Risk: While interest rate risk is eliminated, FMPs still carry credit risk. If an underlying corporate bond defaults or is downgraded, the final payout of the FMP will be negatively impacted.
• Utility: FMPs are utilized by investors seeking predictable returns decoupled from market volatility, provided they do not require liquidity during the lifecycle of the fund.