Liquid funds, like all mutual funds, invest risk, including potentially significant losses. Investors should be aware of the risk and loss potential of liquid fund investments.

Investing in liquid mutual funds is generally less risky – and less rewarding – than investing in mutual stock funds. Similarly, a bank deposit at a fixed interest rate offers lower risk stock mutual funds and lower returns than mutual fund funds.

Yields fluctuate on the debt market and are not guaranteed. Since investments are market-related, the value of the investment may decrease or increase. 

Here is the type of liquid mutual fund risk

Interest rate risk

Bond prices are primarily linked to interest rates.

Due to changes in prevailing interest rates, interest rate risk determines the probability of changing the value of a bond. In reverse ratios, most bond prices fall as interest rates rise. As interest rates are decreasing, bond prices are rising. Generally, the longer the maturity of a bond, the shorter its length, which leads to more fluctuations due to changes in interest rates. Interest rate risk is minimal because liquid funds invest in short-term debt assets and money market securities.

Credit risk

Traditional bank fixed deposits or savings accounts; liquid mutual funds are not insured.

While money market mutual funds invest in high-quality securities and promise to maintain the value of your investment, there is a chance that you may lose money and there is no assurance that you will redeem your units over time, will recover the invested capital.

If the principal and interest cannot be repaid on time by the bond issuer, the bond is said to be in default. A declining credit rating and credit rating of an issuer will reduce its bond prices and the liquid fund NAV holding the securities of the issuer will also decline. Example- On February 22, 2017, Taurus Liquid Fund reported a 7.2% drop in its NAV. A 7 percent drop in equity schemes a day is unusual. 

Inflation risk

Due to the safety and short-term nature of the underlying securities, liquid fund returns are lower than traditional volatility and more volatile assets such as bond mutual funds, thus increasing the likelihood that rates of return may not coincide. Inflation risk is the risk that the increase in the purchasing power of a bond’s fixed interest payment will be compromised.

The higher the maturity of a bond, the greater the probability of inflation. Bond yields often include inflation expectations, allowing investors to be compensated for expected inflation risk. When inflation is raised higher than expected when the bond is issued, investors will find that interest and principal will be lower than what they had expected, resulting in a drop in bond prices, reducing the mutual fund’s NAV.

Inflation risk is low because liquid funds invest in short-term investments. 

Conclusion: Liquid funds are an excellent way to generate better returns than the money lying in the emergency or your bank savings account. Most liquid funds offer 7% to 8% returns, and their profits are also very stable.