Should debt funds be part of an Emergency Fund?

By Mohasin Athanikar |  28-05-21 | 

The one-year return of liquid funds, on an average, is not even 3%. This is pathetic. It makes sense to put money here for very short periods of time. But does it make sense to invest in it when it comes to my Emergency Fund, or should I stick to a bank fixed deposit?

This question was presented to us by a reader. Before we directly address that issue, it is worth noting what investments must be part of an Emergency Fund.

When it comes to an Emergency Fund, the focus is safety and liquidity. It is not a tool to create wealth. Hence, returns take a back seat.

What must comprise an Emergency Fund portfolio are various types of debt instruments. However, no instrument with a lock-in period, such as the Public Provident Fund, or PPF, can be part of an this corpus. It is foolish to have equity investments as part of an Emergency Fund since the volatility of the asset will defeat the basic purpose of capital preservation and liquidity. One may need the money during the depths of a bear market, and would be forced to sell investments at a huge loss.

Now let’s attempt to answer the query.

Why the returns have not been impressive.

The slowdown in the economy got exacerbated by the pandemic and the consequent lockdowns. Since 2019, the Reserve Bank of India has cut the policy rate sharply (250 bps) and announced a slew of measures to support the economy.

The fall in interest rates along with abundant liquidity in the banking system resulted in yields falling across the yield curve, particularly at the shorter end. This sharp fall is also reflected in the yield to maturity (YTM) of funds across the shorter duration spectrum. This is the reason liquid funds have delivered low returns over the past year.

Banks too have cut down on both savings and fixed deposit (FD) rates offered to investors, owing to surplus liquidity amid low credit off-take and access to low-cost funding from the central bank.

The other costs.

Pre-mature withdrawals in case of bank fixed deposits are charged a penalty on the interest earned. Liquid funds are charged miniscule exit loads on the invested amount for redemptions only within the first six days.

If your investment in a liquid fund (like other debt mutual funds) is held for more than three years, on redemption, tax is levied on long-term capital gains (LTCG). The amount is 20% post indexation. If the investment is held for  up to three years, then short-term capital gains (STCG) taxation is applicable. Here the gain is added to the overall income and taxed according to the tax slab of the investor.

Interest received on fixed deposits is taxed each year at the marginal tax rate. What this means is that the interest earned is added to the overall income, and taxed according to the tax slab of the investor.

But do remember that in the case of bank fixed deposits and savings accounts, the interest earned up to Rs 10,000 per annum is tax deductible under section 80TTA (Rs 50,000 in case of senior citizens under section 80TTB).

Making a choice.

Liquid and Overnight funds meet the prime requirements of safety and liquidity. Both are open-ended debt fund categories that invest in high credit quality instruments entailing minimal credit and duration risk.

Both types of funds have portfolios diversified across high credit quality instruments with minimal duration risk. They are typically accessible within T+1 days (T being date of redemption).

Overnight funds invest in securities that mature in one day; reverse repo, TREPs and other debt instruments that mature in one business day. On the other hand, liquid funds can invest in securities maturing in up to 91 days, such as T-bills, commercial paper, certificates of deposits, repos and instruments. The average maturity of liquid funds being around 1-2 months.

Banks fixed deposits are not market-related investments like the above, but are guaranteed return instruments. You know exactly what you are going to get at the time of investment, and  for what period.

Given the very short tenor of the underlying instruments, the YTMs of these funds closely track interest rates in the money market as the maturity proceeds of underlying instruments are rolled over and invested at the prevailing market rate. Currently, the yields are low due to low short-term borrowing costs amid surplus liquidity conditions. As the economy picks up steam, interest rates are likely to move upwards and so will the YTMs offered by such funds.

What is yield?

In conclusion.

Given that interest rates offered on very short tenor deposits (<6 months) are somewhat comparable to YTMs on liquid funds, investors deciding between liquid funds and bank FDs should consider their liquidity needs, investment horizon and applicable taxation.

Our suggestion would be to have an Emergency Fund that has a mix of all these investments, such as a bank fixed deposit and a liquid fund. It need not be one to the exclusion of the other.

Do read, Do you need debt funds in a portfolio?

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Dec 5 2021 05:33 PM
 High interest savings account carry their own risk of default.
Emergency funds need to be liquid as well as safe. Returns are secondary concern.
PSU or large private bank FDs are safe.
Liquid and short term debt funds are also quite safe with additional advantage of tax efficiency.
6 months of expenses are advised as emergency corpus.
I think 1 month amount should be kept in savings account of a psu or large private bank for immediate liquidity needs.
Rest can be divided into fd and debt funds to diversify whatever minimal default risk exists. Debt funds take 1 business day for redemption but some funds now offer immediate redemption too with atm. FDs can be broken and accessed on same day usually but carry penalty. So in case of need use Savings account money first followed by redeeming debt fund and then breaking fds if needed.
So I agree with author about using a mix of available options for emergency corpus creation.
ninan joseph
May 30 2021 04:25 PM
 The author acknowledges that return is not the factor in an emergency fund, but still the conclusion is to have a mix of all these three.
I totally disagree on the conclusion. It can never be a mix of any of these investments. It has to be Bank savings bank account, similar to RBL bank who offers tired interest rate or Bank FD. The only point that you should worry is the limit on their ATM and can the card be used for POS.

If a person is in the process of creating an emergency fund, the best option is to open a recurring deposit with a tenor 12 to 24 months as these months he will be creating the corpus.

Once he has created the corpus he can do the following:-

Place this money in bank savings bank account with gives rate of 4.5 to 6% like RBL bank or IDFC bank
The customer can alternatively open FD for shorter period if he is not certain. The other alternative is to create a long term FD and then seek an OD against this FD. This will ensure that the fund is generating returns and in case of emergency you have the option of taking it from the OD. Interest is charged only if the amount is drawn

Most of the experts advise against FD for the following reasons
Tax Inefficiency - Just fill in form 15G and submit it to the Bank, no TDS will be deducted.
One half wit expert on CNBC was saying that if you have cash available, then the person will use it. If you have this problem, no one in this world can help you. You will even sell your kitchen utensils to make money and use it.
The above are for people who have some amount of discipline in their life.

I really wonder, how these experts can give so blatantly wrong advise to customers. The very definition of emergency is you need money in the middle of the night and returns are not an issue. When this is the theme, they are telling people to put the money in a mix of liquid fund.
Even if they say, put half in SB account and Half in FD, I would have agreed.
Arnav Chauhan
May 30 2021 02:00 PM
 High interest savings accounts with co-operative/small finance banks and Bandhan bank for example might also be an option right? Why not go for those rather than debt MFs?
Shriniwas Dandekar
May 29 2021 04:43 PM
 Can we invest in Ultra short term funds or Low duration funds ? They give slightly beter returns and equally safe & liquid .
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