Should you add debt funds as part of the emergency fund?
When it comes to an emergency fund, security and liquidity are the most important factors to consider. It is not a way to accumulate wealth. Returns, therefore, take a secondary place. It is important to understand what investments should be included in an emergency fund.
Different types of debt securities should be included in an Emergency Fund portfolio. However, this corpus cannot include instruments with a blocking period. Equity investments in an emergency fund are a bad idea because the volatility of the asset defeats the primary purpose of capital preservation and liquidity. In the depths of a bear market, one may need funds and be forced to sell investments at a significant loss.
How does Bank FD as an emergency fund charge compared to debt funds?
In the case of term bank deposits, early withdrawals are subject to a penalty on the interest collected. For redemptions during the first six days, Liquid Funds levy a small exit charge on the amount invested.
If you invest in a liquid fund (like other bond mutual funds) for more than three years, you will be taxed on the long-term capital gains when you redeem (LTCG). After indexation, the sum is 20%. Short-term capital gains tax (STCG) applies if the investment is held for less than three years. The profit is then added to all income and taxed according to the investor’s tax bracket.
Fixed bank deposits are not market-linked assets like debt funds, but they do offer a guaranteed return. You know exactly what you will get and for how long when you invest.
Cash and Overnight Debt Funds
The main preconditions of security and liquidity are met by liquid and overnight funds. Both are types of open-end debt funds that invest in high credit quality securities with low credit and duration risk. The portfolios of both types of funds are diversified among high credit quality products with low term risk. They are generally available within T+1 days.
Overnight funds invest in securities with overnight maturities, such as reverse repos, SERPs and other debt securities with overnight maturities. Liquid funds, on the other hand, can invest in assets such as treasury bills, certificates of deposit, commercial paper, repos, and instruments with maturities of up to 91 days. Liquid funds have an average maturity of 1-2 months.
Because the underlying securities have such a short maturity, the yield to maturity of these funds closely tracks money market interest rates, as the proceeds at maturity of the underlying assets are rolled over and invested at the current market rate. Interest rates should rise if the economy improves, as should the yield to maturity of these products.