Investing in Money Market Funds - What is a money market fund?
Money markets are an integral function of an economy's financial system; wherein short duration financial securities are issued. While corporations use it to bridge the short-term funding requirements, financial institutions, including banks, use it for liquidity management. However, retail investors may not be able to generally invest in money market instruments due to the large-ticket transaction sizes. Such investors can have similar investment exposure through money market funds.
What is a Money Market Fund?
A money market fund is such a fund that invests in money market instruments with a maturity of up to one year. Due to the lower duration of such funds, the valuation of the money market instruments in the portfolio is not impacted significantly by the market's interest rate movements. Thus, such funds tend to carry lower interest rate risk as well.
Such funds occupy a 6% share across all open-ended debt funds with an AUM (Assets under Management) figure of Rs. 0.66 lakh crores (data as of 30th June 2020). Source: Association of Mutual Funds of India - AMFI).
Instruments which money market funds invest in
Money market funds may invest in a range of money market instruments, like T-Bills (Treasury Bills), CPs (Commercial Papers), Certificates of Deposit (CDs), Repo securities, etc. While some of the money market instruments may be sovereign securities, the other instruments are tightly regulated in terms of entities that can issue such securities.
The entities issuing such instruments are generally top-rated entities that further mitigate the credit risk and liquidity risk for the investment portfolio. An additional key feature for money market instruments is that such securities are issued at a discount and redeemed generally at face value. The difference between the issue price and face value represents the interest differential for such instruments' tenor.
Taxation of Money Market Funds
As per Income Tax laws, mutual funds can be classified into equity-oriented funds and other funds based on the net assets invested in equity securities. An equity-oriented fund must invest at least 65% of its net assets in equities and equity-related securities. Since money market funds invest its net assets in money market securities, such funds are categorised as other funds.
The appreciation in the mutual fund scheme's valuation, represented by NAV, is taxed as capital gains on redemption of such mutual fund units. Depending on the holding for such units, the gains can be classified as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG).
For money market funds, the cut-off period for classification as LTCG is 36 months. As such, the gains will be classified as STCG if the holding period is less than 36 months and taxed at the regular tax rates as applicable to the investor. If the holding period is 36 months or more, the gains will be classified as LTCG and taxed at 20% after indexation benefit.
Why invest in a money market fund?
The risk categorization of such funds tends to be low, considering the lower duration of the money market securities. As such, conservative investors may consider investing in such funds to generate reasonable income with high liquidity levels.
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.