Understanding Liquid Fund Returns in the Upcoming Months

Are you expecting a decline in liquid fund returns in the upcoming months? This article will delve into the factors that influence these returns, particularly in relation to the interest rate cycle.

Introduction

Debt funds, including liquid funds, are significantly impacted by the interest rate cycle. When interest rates decline, the returns on all debt funds and interest-sensitive instruments (such as Fixed Deposits and Recurring Deposits) tend to decrease. Conversely, when interest rates rise, returns can increase.

Liquid Funds Overview

Liquid funds primarily invest in debt securities maturing within 91 days. This means that every 91 days, the liquid fund scheme will have an entirely new set of debt papers. This is an essential characteristic to consider when evaluating the performance and returns of liquid funds.

Current Conditions and Expectations

The current RBI (Reserve Bank of India) repo rate as of the time of writing is 5.40%. Accordingly, if we assume a general rule that liquid fund returns are 0.50% higher than the RBI repo rate, the current yield from liquid funds can be approximated to 5.90% per annum.

Example Scenario

Let's consider a simple example to illustrate the impact of interest rate changes:

Day 1: Expected returns are 5.90%. You invest your money in the liquid fund, and it buys papers yielding 5.90%. Day 57: If the RBI decreases the repo rate by 40 basis points (0.40), the new repo rate becomes 5.00%. Consequently, the returns available to the liquid fund will decrease to 5.50% (5.90% - 0.40%). Day 91: The liquid fund has to replace the old papers with new ones yielding 5.50% for the next 91 days.

This scenario demonstrates the direct impact of interest rate changes on liquid fund returns.

Interest Rate Cycle and Fund Duration

The impact of interest rate changes on returns varies based on the duration of the fund. General rules of thumb include:

Declining Interest Rates: For declining interest rates, higher-duration funds benefit more. When interest rates decrease, the value of these longer-term papers increases, and newer papers offer lower yields, potentially raising the NAV (Net Asset Value) of the fund. Rising Interest Rates: In contrast, lower-duration funds are preferable when interest rates are increasing. These shorter-term funds provide better returns more quickly, helping investors to re-invest in newer, higher-yielding securities sooner.

As an amateur looking to invest and hold, it is advisable to stick to funds with a shorter duration (approximately 1 year) for the debt portion of your portfolio. Investing in longer-duration funds requires knowledge and skill to navigate the interest rate cycle, which may not be suitable for all investors.

Comparison with Fixed Deposits

The returns of liquid funds are generally in line with the interest rate cycle. While it is challenging to achieve returns significantly higher than the prevailing interest rate, liquid funds often outperform fixed deposits due to tax considerations over a longer period. Within shorter periods, like three months, liquid funds may yield less than the prevailing interest rate or fixed deposit returns.