With liquid funds, it’s all about timing and tax treatment

Parking your surplus money for a very short time-frame in liquid funds may seem like a good idea as they offer relatively better returns than bank deposits on a post-tax basis for investors in the 30 per cent tax bracket.

But choosing between the growth and the dividend options and the timing of your investment will be critical determinant of the wisdom of your decision.

Just like any other mutual fund, liquid funds also come with two options: growth and dividend. Under the growth plan, units redeemed before 36 months attract short-term capital gains tax and the returns are taxed at the slab rates. Units that are redeemed after 36 months attract long-term capital gains tax at the rate of 20 per cent, with indexation benefits.

On the other hand, under a dividend plan, while dividends declared by funds are not taxable in the hands of the individual, all non-equity funds attract a dividend distribution tax (DDT) of 28.84 per cent, which is deducted and then given to the investor.

Thus, the tax treatment plays an important role in deciding the investment option.

When not to invest If you wish to park your money in liquid funds for a very short period, say, less than 10 days, you need to be careful while investing in the dividend plan of liquid funds — under the monthly, quarterly, half-yearly or yearly options.

Entering into such dividend options a few days prior to the record date can lead to a loss in capital while redeeming the units. Why is that so?

Under the dividend option, the NAV of the fund falls to the extent of the total gross dividend after the payout is made. But the net dividend that you receive is after the deduction of the DDT.

Hence, you will end up getting only 71.16 paise on a dividend of ₹1 declared by the fund. The NAV of the fund, though, gets adjusted to the extent of the gross dividend (₹1).

Since you are a very short-term investor, you will have to bear this loss in capital. The table depicts this loss under two different liquid funds with different payout options — ‘HDFC Liquid Fund Monthly Dividend’ and ‘Reliance Liquid-Cash Plan Quarterly dividend’. The capital of ₹1 crore is invested one or two days prior to the record date and redeemed on the 5th day.

When to enter and exit To make good the loss, you must stay invested for at least 10 days under a monthly dividend option or at least 25 days under a quarterly dividend option.

If you have invested in the half-yearly or yearly option, you will have to stay invested for a much longer period to recoup your capital loss.

Another way to avoid such losses would be to invest in the daily dividend pay-out option, as the NAV will more or less remain unchanged on a day-to-day basis.

At the same time, it is important to note that investments done in the same monthly or quarterly dividend option, post the record date, will not lead to a capital loss. Hence you can redeem at any point of time.

Is the dividend option for you? Investors can keep their short-term money in their savings account itself. Savings accounts score better from a tax perspective; interest up to ₹10,000 is exempt under Section 80TTA of the Income Tax Act.

If we assume 7 per cent returns on liquid funds, the post-tax returns work out to 6.3 per cent, 5.6 per cent and 4.8 per cent, respectively, for individuals in the 10, 20 and 30 per cent tax bracket. This is higher than the 3-4 per cent that most banks offer. A few banks offer a higher 5-6 per cent interest on high-value deposits.

However, if you hold over ₹2.5 lakh in the savings accounts, liquid funds would still offer better returns.

Investors in the 10-20 per cent bracket can opt for the growth option rather than the dividend option since the effective tax rate will be lower under the growth option.

For investors in the 30 per cent tax bracket, the dividend option (after factoring in DDT at 28.84 per cent) may be a better route as any redemption before 36 months will attract tax at 30.9 per cent.

In case the investor’s income exceeds ₹1 crore, remember that short-term capital gains tax will be higher at 35.53 per cent due to the surcharge of 15 per cent

Is now a good time? The interest rates offered by bank deposits and other small saving schemes have been drifiting lower in recent years, given that the interest rate in the Indian economy has been sliding down.

Considering this, investing a portion of your surplus in liquid funds, which have been delivering better returns, may seem a sound idea.

But after raking in 8-9 per cent gains in the past couple of years, liquid funds have now seen a moderation in returns over the past year. This trend is likely to continue in the near term.

Liquid funds invest only in debt securities with a residual maturity of less than or equal to 91 days. The lower maturity mitigates interest rate risk, along with credit risk (default risk). Liquid funds invest in fixed maturity interest-paying instruments, such as call money, CBLO, Repo, Reverse Repo, commercial papers (CP), non-convertible debentures (NCD), certificates of deposit (CD) and Treasury Bills (TBs).

As per SEBI regulations, non-traded securities that have a residual maturity of up to 60 days do not have to be marked to market, with certain exceptions to this rule. For listed securities (such as TBs and NCDs), mark-to-market valuation applies irrespective of the residual maturity.

Since a chunk of liquid funds’ investments are in securities with maturity of up to 60 days, these have to be valued on an accrual basis.

This is what makes the NAV of a liquid fund less volatile. But this is also why returns from liquid funds lag those of ultra-short-term and short-term debt funds.

Falling returns Since liquid funds earn returns through accrual, rate movements on money market instruments matter. Thanks to the RBI’s decision to move towards a neutral liquidity regime in April 2015, short-term rates continue to tag the repo rate, which is currently at 6 per cent. Even if the RBI does not lower its repo rate from here onwards, the ample liquidity in the system will keep the spreads of money market instruments over repo rate narrow.

This will, in turn, impact the returns delivered by liquid funds as a category. In 2016, liquid funds as a category delivered 7.5 per cent returns, lower than the 8-9 per cent they delivered between 2011 and 2015. This falling or lower trend is expected to continue over the near to medium term, with returns possibly hovering around 6.5 per cent levels. At these levels, post-tax returns from liquid funds are higher than the rates currently offered by bank FDs. However, since savings accounts score better from a tax perspective, some of these deposits may score over liquid funds currently. But remember, the current falling rate trend on short-term securities can reverse. Liquid funds can then, once again, turn attractive.

Indexation benefit Low-risk investors with a time horizon of more than 36 months can invest in growth option of liquid funds. The gains on the units redeemed after 36 months attract long-term capital gains tax at 20 per cent with indexation. Under this, the cost of investment and redemption amount are adjusted with the inflation index and then taxed. In this case, the tax will be almost nil or negative (which can be carried forward against other long-term capital gains subject to conditions). This indexation benefit is not available on bank FDs.