Experts are increasingly advising investors to consider liquid funds and money market funds as alternatives to fixed deposits (FDs). This recommendation stems from a combination of factors, including greater liquidity, potentially better returns, and tax efficiency, especially for those in higher income brackets.

Understanding Liquid Funds

Liquid funds are a type of debt mutual fund that primarily invests in short-term debt instruments with maturity periods of up to 91 days. These instruments include treasury bills, commercial papers, and certificates of deposit. The primary objective of liquid funds is to provide a high degree of liquidity while preserving capital and generating reasonable returns.

Key Advantages of Liquid Funds

• High Liquidity: Liquid funds offer investors easy access to their funds, with redemption requests typically processed within 24 hours. Some funds even offer instant redemption facilities. This high liquidity makes them suitable for parking surplus funds or emergency savings.
• No Lock-in Period: Unlike FDs, liquid funds do not have a lock-in period, allowing investors to withdraw their investments whenever needed.
• Low Risk: Liquid funds generally invest in high-credit quality debt instruments, making them relatively low-risk compared to other investment options like equity or long-term debt funds.
• Competitive Returns: Liquid funds have the potential to deliver better returns than traditional savings accounts.
• Low Interest Rate Risk: Due to their investments in short-term instruments, liquid funds carry the lowest interest rate risk among debt funds. They are less affected by fluctuations in interest rates compared to longer-term bonds.
• Versatile Uses: Liquid funds can serve as an alternative to savings accounts, a place to park funds temporarily, or an emergency fund.

Understanding Money Market Funds

Money market funds (MMFs) are another type of mutual fund that invests in highly-rated, short-term debt securities, such as Treasury bills, municipal bills, and short-term corporate and bank debt. These securities typically have maturities under 12 months. MMFs aim to generate income while maintaining a low risk profile.

Key Advantages of Money Market Funds

• Safety and Stability: MMFs are considered one of the least volatile types of investments. They provide a secure, short-term investment option.
• Liquidity: MMFs generally invest in securities with high demand, making them very liquid. Investors can typically buy and sell them with ease.
• Diversification: MMFs offer portfolio diversification by investing in a variety of short-term debt securities.
• Competitive Yields: MMFs generally offer better yields than standard bank savings accounts.

Disadvantages of Fixed Deposits

• Lower Returns: FDs typically offer fixed interest rates, which may be lower than the returns offered by other investment options like stocks, mutual funds, or liquid funds.
• Lock-in Period: Once invested in an FD, the money is locked in for the term of the deposit, limiting access to funds in case of emergencies.
• Taxability of Interest: The interest earned on FDs is taxable income, which reduces the overall returns. Tax is deducted at source (TDS) if the interest income exceeds a certain threshold.
• Inflation Risk: If the interest rate on an FD is less than the inflation rate, the real value of the investment diminishes over time.
• Reinvestment Risk: Upon maturity, investors may not be able to reinvest their funds at the same or a higher interest rate if market interest rates have declined.

Tax Implications

The taxation of liquid funds and FDs differs, which can impact the overall returns, as of July 31, 2025:

• Liquid Funds: Capital gains from liquid funds are subject to taxation. For liquid funds purchased on or after April 1, 2023, all gains are taxed as short-term capital gains (STCG) based on the investor's income tax slab rate, regardless of the holding period. Dividends from liquid funds are taxed as per the investor's income tax slab, with a 10% TDS on amounts exceeding ₹5,000.
• Fixed Deposits: Interest income from FDs is fully taxable and added to the investor's total income for the year. The tax rate depends on the investor's income tax slab. Banks deduct TDS on FD interest income if it exceeds certain limits: ₹50,000 for regular depositors and ₹1 lakh for senior citizens. The TDS rate is generally 10%, but it can be higher if PAN details are not furnished.

Risks to Consider

While liquid funds and money market funds are generally considered low-risk, they are not entirely risk-free. Potential risks include:

• Credit Risk: The possibility of default by the issuers of the underlying securities.
• Interest Rate Risk: Changes in interest rates can influence the returns of liquid funds.
• Inflation Risk: The risk that the investment's purchasing power may decline due to inflation.
• Liquidity Risk: The risk that the fund's liquidity may be insufficient to meet redemptions.
• Market Volatility: Although rare, liquid funds may deliver negative returns if the net asset value (NAV) of the fund decreases.

Conclusion

Liquid funds and money market funds offer several advantages over fixed deposits, including greater liquidity, competitive returns, and potential tax efficiency. While FDs provide guaranteed returns and are considered safe, their lower returns, lock-in periods, and tax implications may not be as attractive for all investors. Investors should carefully consider their financial goals, risk appetite, and investment horizon before making a decision. Diversifying investments and consulting with a financial advisor can also help optimize investment portfolios and achieve both short-term and long-term financial goals.