Liquid funds: Check long-term ratings for clearer view of portfolio quality

Assess the track record of the fund during past liquidity incidents

With savings bank (SB) account returns declining, retail investors are turning to liquid funds. These funds added 220,000 folios in 2025, up to July 31, compared to 64,300 in 2024 and 4,345 in 2023, according to a recent Business Standard report.

 

Liquid funds invest in securities with maturities of up to 91 days, including treasury bills, commercial papers, certificates of deposits and other money market instruments. Some funds offer instant redemption up to a limit, though most follow a T+1 cycle. Requests submitted before 2 p.m. are settled the next day.

 

Reasons for the shift

 

Larger banks have cut savings rates to 2.5–3 per cent. “Investors in liquid funds can earn 25–50 basis points more than the Reserve Bank of India’s repo rate (currently at 5.5 per cent),” says Jalpan Shah, head–fixed income, TRUST Mutual Fund. 

In the past, investors shifted to higher-risk products when interest rates fell. “This time greater risk awareness and past experiences have led to a preference for liquid funds,” says Mahendra Kumar Jajoo, chief investment officer–fixed income, Mirae Asset Investment Managers (India).

 

Efficient for short-term parking

 

Liquid funds are efficient for parking short-term surpluses. Interest-rate risk is minimal in these funds. “Since they invest only in up to 91-day securities, they carry lower duration risk,” says Anurag Mittal, head of fixed income, UTI Asset Management Company (AMC).

 

Credit risk tends to be low with fund houses emphasising high-quality portfolios.

 

Regulations require these funds to maintain a minimal level of liquidity. “The Securities and Exchange Board of India (Sebi) requires at least 20 per cent of the portfolio to be in high-quality liquid assets, typically treasury bills,” says Jajoo.

 

Since these funds do not charge an exit load once seven days have passed since allotment, investors enjoy high liquidity.

 

Unlike bank deposits, which carry penalties for premature withdrawal, these open-ended funds do not impose such levies. Low minimum investment amounts make them easily accessible.

 

Risks and downsides

 

The returns are market-linked and not fixed. Liquid funds can occasionally show negative net asset value (NAV) movement. “But that is a very rare event,” says Jyoti Prakash, managing partner, equity and PMS, AlphaaMoney.

 

Immediate redemption is not available in all liquid funds. “It is not like an ATM card from which you can immediately withdraw money,” says Prakash.

 

Investors must also be mindful of the exit load during the first seven days. “Most liquid funds have a graded exit load, which can range from 0.0007 per cent to 0.0012 per cent per day,” says Nikunj Saraf, chief executive officer, Choice Wealth.

 

Taxation is another issue. “All gains are taxed at the income tax slab rate. For someone in the 30 per cent tax bracket, a 6.5 per cent return from a liquid fund becomes 4.55 per cent,” says Saraf.

 

Checks before investing

 

Investors must ensure that the fund invests in highly-rated money market instruments. “While most investments have top short-term ratings (A1+), investors should also check the corresponding long-term ratings. These can range from AAA to A+, which shows the actual portfolio quality,” says Shah.

 

The regulator requires every fund to disclose its potential risk class (PRC) matrix. “Liquid funds that have classified themselves in PRC A-I must invest only in the highest-rated issuers based on long-term ratings and offer the lowest potential credit risk,” says Shah.

 

Mittal advises avoiding funds concentrated in a particular sector. He also stresses checking the fund’s track record during past liquidity incidents. Consistency in returns, according to him, is preferable to chasing outliers.

 

Mistakes to avoid

 

According to Prakash, many investors forget to submit redemption instructions before the cut-off time and also fail to account for the one-day cycle. Saraf cautions that some treat liquid funds as instant emergency money without considering the exit load in the first week, and others ignore portfolio quality.