Emergency funds in a portfolio are for dealing with unforeseen requirements
Even though an emergency fund should be liquid, it is not something you always need
The ongoing covid-19 crisis has further highlighted the importance of having an adequate emergency corpus. With so much uncertainty about what could happen in future, you may be wondering if you should hold a portion of your emergency corpus in liquid funds or move the entire sum into safer options such as bank savings accounts, especially because liquid funds have seen greater volatility in net asset values (NAVs) recently, owing to liquidity-led disruptions in the debt markets. Disha Sanghvi asks four industry experts if liquid funds are still a good option, or if it’s time to cut your losses and move on.
Divide corpus between cash, bank deposit and liquid fund
Once you have estimated the appropriate size of your emergency corpus, it needs to be divided into multiple components, rather than treating it as one single chunk of money.
It may be prudent to hold about 15 days of expenses in physical cash at home to tide over situations where access to electronic banking or cards is impaired. An additional 15 days of expenses should be kept in a bank account that has an automatic two-way sweep feature to move the excess balance over a certain minimum into a fixed deposit and vice-versa. The balance should be put in a liquid fund.
The volatility of liquid funds tends to be rather short-lived, going by history, as the regulations require liquid funds to hold only papers with up to 91- day maturity. Thus, investors who are prudent in terms of sticking to funds with high credit quality, large assets under management (AUMs) and low modified durations should choose liquid funds to support their emergency corpus needs beyond a month, especially if they are in a higher tax bracket, as the emergency corpus may actually be held for much longer than estimated.AMCs
Still suitable but go for good long-term track records
An emergency fund is defined as an essential corpus that you must keep aside to tackle uncertain events. It must be designed to meet any unanticipated financial shortfalls arising from unplanned scenarios.
The two definitive characteristics must be safety of capital and immediate liquidity. Even though an emergency fund should be liquid, it is not something you always need. So invest it in a manner that helps you earn decent returns from it without compromising on liquidity.
Liquid funds are debt funds that invest in short-term fixed-interest-generating money market instruments with maturity within 91 days. Earlier in April, for a short period of time, there was extreme stress in the money markets and liquid funds delivered negative returns for a few days. The Reserve Bank of India (RBI) intervened and infused liquidity to ease the stress. But this was an exception. We had last witnessed similar stress during the global crisis in 2008.
Liquid funds continue to be a suitable instrument for parking emergency funds. Therefore, rather than basing decisions on one-off events, consider the long- term track records of funds.Keep holding funds that can tide over the liquidity woes
Keep holding funds that can tide over the liquidity woes
Investing emergency corpus in liquid funds has been a regular practice. It is preferred for its easy liquidity and ability to generate better returns than savings bank accounts.
But the recent volatility in debt funds has shaken investors’ confidence. Liquid funds are likely to see significant outflows given the lack of liquidity in the financial system and that businesses will need money after the lockdown ends. This can cause some stress on funds which do not have adequate financial support. Bank-backed AMCs will be better placed to overcome the volatility as they can borrow from their parent companies to fund redemptions.
In the absence of liquidity, redemption pressure may lead to distress selling of assets, resulting in mis-pricing of illiquid debt investments and erosion of net asset value (NAV). So, if you are holding liquid funds which are capable of tiding over these liquidity concerns, continue to do so.
The current liquidity crisis is bound to blow over and that should lead to the debt markets returning to normalcy. Investors who have no urgent need for money should, therefore, stay invested.
Holding liquid funds for 30 days would mute volatility
Emergency funds in a portfolio are for dealing with unforeseen requirements. The basic premise is complete safety of capital, very high liquidity and reasonable returns.
Bond yields were extremely volatile in March as FPIs sold a record amount of Indian debt. Coinciding with fiscal year end accentuated liquidity squeeze leading to a rise of 100-250 basis points in yields, including the short end, and even liquid funds showed negative returns briefly. RBI’s actions helped in softening bond yields. The infusion of ₹1 trillion under the TLTRO 1.0 reduced the volatility in bond market and stabilized liquid fund returns. RBI also committed to keeping financial system stable and liquid.
Now, the yields in liquid funds have declined closer to the operative policy rate. Some volatility could continue given the covid-19 crisis, the fact that all securities are marked to market, and the low starting yield to maturity. If they are held for at least 30 days, volatility will be mostly muted, given high credit quality. The returns from the overnight segment will be significantly lower, given the huge liquidity surplus in the system.
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