Types and Benefits of Money Market Funds

Published On: 12-Aug-2020

When it comes to debt investments, the investors are generally inclined to the traditional investment products like bank deposits. However, one can also invest in debt funds to have investment exposure towards debt securities. Of such categories, mutual fund schemes that invest in money market securities of up to one year are classified as money market funds

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While such funds are one of the mutual fund categories allowed by SEBI, a broader classification may comprise the following types of funds investing in money market instruments:

1. Overnight Funds – Investing in overnight securities with a maturity of one business day.

2. Liquid Funds – Investing in securities with maturity of up to 91 days.

3. Money Market Funds – Investing in money market instruments with a maturity of up to one year.  

While there are some other mutual fund categories with lower duration, the determining factor for such classification for those funds is Macaulay Duration, which may also vary due to the interest rate reset or put/call options in the invested securities. However, the above three types of money market mutual funds categorically invest in securities with shorter maturities only. These three types of funds occupy a substantial 48% share amongst the open-ended debt fund universe with an AUM (Assets under Management) figure of Rs. 5.62 lakh crores (data as on 30th June 2020.)

Source: Association of Mutual Funds of India - AMFI).

Major Money Market Instruments 

One common feature amongst money market instruments is that such securities are issued at a discount to the face value. Such a discount represents the implied interest cost for such securities. Money market funds may invest in the following types of money market instruments:

  1. Treasury Bills (T-Bills) – Such securities are Sovereign securities and are considered risk-free investments. Such securities may be issued for 91 days, 182 days, and 364 days.

  2. Certificate of Deposits (CDs)Financial institutions like banks issue a Certificate of Deposit or CD for the short-term. 

  3. Commercial Papers (CPs) Commercial Papers are instruments issued by Corporates to bridge their short-term funding requirements. To aid the liquidity of such instruments, these are generally listed on stock exchanges.

  4. Repurchase Agreements (Repo)Repurchase Agreements, also known as Repo/ Reverse Repo operations, are carried out between the authorized parties and are undertaken with the help of underlying securities like treasury bills, central or state government securities, corporate bonds, and PSU bonds.

Benefits of Money Market Funds

With high-rated and sovereign entities involved in issuing the money market securities, such funds carry insignificant credit risk. Further, the maturity of money market securities in such funds cannot, in any case, be more than one year, and thus, the consequential interest rate risk is moderately low. As such, the investors can aim to generate reasonable returns with moderately low risk with money market funds. 

Taxation of Money Market Funds

The gains from money market funds must be classified as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) based on the holding period by the investors. If the investors have held such mutual fund units for less than 36 months, the gains are taxed as STCG at the regular tax rates as applicable to the investor. 

If the holding period is 36 months or more, the gains are taxed as LTCG with a tax rate of 20% after providing the benefit of indexation on the invested amount. The indexation benefit allows the investors to adjust the invested amount for prevailing inflation, as per the Cost Inflation Index (CII) notified by the Govt. As such, the effective tax rate on LTCG on such funds is even lower than 20%. 

Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Union Budget 2020 passed by the Parliament. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.