Liquid funds are quite popular within the debt fund realm. They typically invest in short-term debt products, with a maturity of no more than 91 days.
In brief, liquid funds invest in debt instruments where the borrower agrees to return the principal sum within 91 days of taking the loan.
An illustration of this could be Power Finance Corporation (PFC) of India, which has a working capital requirement of 150 Crs. To meet this need, they have agreed to pay 8.5% interest to the lender and would be repaying the borrowed amount within 50 days.
HDFC AMC has 150Cr to invest and see this as a great chance to make 8.5% interest, so they direct the funds to PFC.
It is a done deal now.
Fifty days after the loan was taken, PFC compensated HDFC AMC with 150Cr and 8.5% interest.
When any interest or coupon rate is cited, it is expressed yearly. Therefore, 8.5% pertains to the 365 days. Over 50 days, the interest charged will be prorated.
= (50 * 8.5%)/365
HDFC AMC will receive a total of 1.896Cr, comprising 150Cr and 1.746Cr from PFC.
As I mentioned before, a liquid fund is restricted to investing in debt with a maturity of 91 days at the most. Corporate organisations often resort to short-term borrowing. To do so, they issue something called ‘commercial paper’ or CPs. For instance, PFC allegedly issued a CP with a lifespan of 50 days and was taken up by HDFC AMC.
The Government raises funds for short-term requirements through the issuance of treasury bills rather than commercial paper. Their three t-bill options vary in terms of the amount borrowed and duration over which it is repaid.
91-day Treasury Bills have a maturity of 91 days.
A 182-day Treasury bill has a maturity period of six months.
365-day T-bills have a maturity of one year, minus one day.
This website provides information on the topic of treasury bills, or T-Bills.
As a lender with 100 Crs to invest, you have two potential borrowers, each asking for the same amount.
A sugar producer is offering a 6.5% coupon to those interested.
on its 10-year bond, with the 6.5% coupon payable annually.
You can confidently give to the Government, since you won’t have to worry about whether or not they will repay-it’s a sure thing. On the other hand, when it comes to the sugar manufacturer, that’s not a guarantee.
It is unlikely the sugar manufacturer will secure the necessary funds. Without a coupon that is higher than their equivalent T-bill, the lender will be reluctant to take on the credit risk involved in lending.
The sugar manufacturer should offer a competitive rate, such as 7 or 8%.
Company A and Company B. Both of these firms manufacture sugar, and both of them do it with a high degree of efficiency and quality.
Company A has been successful for 25 years, yielding notable profits and reliable cash flows.
Company B has been active for five years, and is supported by young entrepreneurs. It has achieved financial stability with its operations.
You’re looking to lend out a sum of 100 Crs. Both options offer you 8%. You have the funds; who will you make your decision in favour of?
Company A is the better choice, given its more solid financial background and reduced risk of default.
Company B is eligible for the funds as long as they provide adequate compensation for the lender’s increase in credit risk. Consequently, they may need to offer around 10 to 11%.
A company’s credit rating expresses their credit risk – similar to an individual’s CIBIL score. The higher it is, the more favourable the terms are for borrowing money, as lower interest rates can be expected.
The liquid fund’s portfolio includes both Commercial Paper (CP) and Treasury Bills (T Bills). While T Bills are considered to be safer, CPs have a higher level of risk associated with them.
This is the most vital point to note about liquid funds.
– Why liquid funds?
Investing in liquid funds is an excellent way to safeguard and store idle cash for future use in less than 18 months. It effectively functions as a parking lot for your extra funds.
Question is – why to invest in a liquid fund instead of leaving it in a bank’s savings account? People tend to go with the liquid fund since it generally offers higher returns than the typical return on a bank’s savings account.
The liquid fund is frequently promised as a better option than savings accounts or fixed deposits. Unfortunately, this isn’t necessarily the case. While it may offer higher yields, it also carries certain risks.
Taking into account present conditions, the average SB account provides a rate of 3.5% to 4%, whereas Liquid funds yield about 6%.
The liquid funds of HDFC comprise a range of CPs, which inherently assume credit risk. Here is an overview of the same –
It’s clear that HDFC Liquid Funds holds a variety of CPs. All issuers enjoyed a good credit rating at the time, but as we know, circumstances in markets can alter rapidly. Should an issuer experience a downgrade, this could cause a considerable decrease in liquid fund NAV.
HDFC’s portfolio also consists of Government securities, which include no credit risk, due to the sovereign assurance.
This liquid fund is a good option, but there is still the possibility of losing money if something goes awry. On the other hand, a Savings Account or Fixed Deposit won’t present this risk.
To offer perspective into a potential negative outcome, take this into account –
This NAV graph of Taurus AMC’s Liquid fund saw a drastic fall of close to 7% in a single day of February 2017. This resulted in the investors losing their entire gains and taking a hit on their capital. Recuperation took close to one year for the fund to return to its former levels.
This 7% decline in NAV was caused by the credit rating agencies revising the CPs issued by Ballarpur Industries, owned by Taurus, downwards. These CPs totalled up to 2000 Cr.
I believe reading this news article would be beneficial, as it provides an interesting take on our discussion up to this point.
If you are considering putting money in Liquid funds, be aware of several things:
Make use of your spare funds by investing them instead of letting them sit idle.
You can anticipate a small uptick in your SA account.
Liquid funds are not without risk; investing in them can lead to capital losses.
Opt for a fund with lower default risk, meaning the liquid fund should be composed of more Government securities.