Investors who prefer lower risk always choose investment options which offer them good returns while maintaining liquidity of their funds. Most investors compare the returns on their debt fund investments with bank deposits. When it comes to short-term debt investing, Money Market Funds have been a preferred option among such investors.
Money Market Funds are short-term debt funds. They invest in various money market instruments and offer good returns over a period of up to one year while maintaining high levels of liquidity. The average maturity is one year.
Money Market is an exchange where the trade of cash and cash-equivalent instruments takes place. These instruments have maturities varying from overnight to one year.
Types of MMFs
Treasury Bills or T-Bills
The Government of India issues treasury bills to raise funds for a period of up to 365 days and are very safe. Lower risks also translate into lower returns. Returns are lower than other money market instruments.
Certificate of Deposit
A CD is a term deposit which is offered by scheduled commercial banks which does not have the option of premature redemption. The primary difference between a CD and FD is that CDs are freely negotiable.
Repurchase Agreements or Repos
A repurchase agreement is made between a bank and RBI to facilitate short-term loans. It can also be made between two banks.
Commercial Paper or CP
Companies and financial institutions with a high credit rating can issue a commercial paper which is a short-term, unsecured promissory note allowing entities to diversify their short-term borrowing sources. CPs are usually issued at a discounted rate while the redemption is done on face value. The investor earns the difference.
How do MMFs work?
A money market fund invests in money market instruments with an objective of offering good returns (interest income) and keeping the NAV fluctuations minimal.
Who should invest in an MMF?
They are ideal for investors with lower risk tolerance and an investment horizon of up to one year. Investors with idle cash lying in their savings account can earn better returns by investing in these funds. Short term cash surplus which are not required urgently can be invested.
Factors to consider before investing in MMFs:
Risks and Returns
These are debt funds and carry all the risks applicable to debt funds like interest rate risk and credit risk. The fund manager might invest in instruments with a slightly higher risk component to increase returns. Money market funds offer better returns than a regular savings account. The NAV of these funds changes with a change in the interest rate regime.
Expense Ratio
The returns are not very high so the expense ratio plays an important role in determining your earnings from a money market fund.
Ideally, the funds with a lower expense ratio to maximize returns should be chosen.
Invest according to personal Investment Plan
Money market funds are recommended to investors with an investment horizon of 90-365 days. These schemes can help you diversify your portfolio and help invest surplus cash while maintaining liquidity. Ensure that you invest according to your investment plan.
Taxation
Capital Gains Tax
If you hold the units of the scheme for a period of up to three years, then the capital gains earned by you are called short-term capital gains or STCG. STCG is added to your taxable income and taxed as per the applicable income tax slab.
If you hold the units of the scheme for more than three years, then the capital gains earned by you are called long-term capital gains or LTCG. LTCG is taxed at 20% with indexation benefits.
Bhoi Smrutirekha Dharanidhar