What is a money market fund?
Money market mutual funds are short-term debt funds, with a maturity period of about a year, that invest in treasury bills, commercial papers and certificates of deposit with the objective of offering substantial returns. Money market mutual funds investment, or money market funds, have a high level of liquidity, and the investments are generally diverted towards fixed income securities.
The securities in which a money market fund invests are called money market instruments. These are highly liquid and secure since their issuers have strong credit ratings. These funds are best suited to the needs of investors who are risk-averse and wish to make gains within the short term. Being a high quality, risk-free investment, they offer fairly predictable returns.
As mentioned above, money market funds invest in money market instruments. These are cash instruments, or cash-equivalent ones and can mature in the span of a night or even one year. Here are some instruments traded in the money market in India—
A certificate of deposit (CD) is an instrument offered by scheduled commercial banks to their customers. With a CD, an individual can deposit an amount of money in the bank for a fixed period of time at a predetermined rate of interest. The depositor cannot withdraw the money and interest applicable until it has matured. Unlike fixed deposits (FD), a CD is negotiable. Its rates are regulated by the Reserve Bank of India (RBI).
Treasury bills are an investment instrument issued by the government. Therefore, they are considered to be safe and risk-free. Treasury bills are issued for maturity periods ranging from 91 days to 365 days. With the risk being low, the returns on treasury bills are also low, perhaps the lowest among all other money market instruments.
This refers to an agreement between a commercial bank and the RBI, or two commercial banks, which facilitates short-term loans. Under these, debt instruments are traded at a fixed price and purchased on a later date and at a higher price, with the repo rate being the difference.
Commercial papers are unsecured promissory notes issued by financial institutions with high credit rating. They are issued to the investor at a discounted price and redeemed at their face value upon maturity. Considered to be high-return investments, CPs usually reach maturity after 270 days.
Gains made from investment in money market funds are taxed like debt funds. They are liable for capital gains tax. Units of money market funds held for less than three years are taxed as short-term capital gains tax as per the relevant income tax slab. For holdings that exceed three years, a long-term capital gains tax is levied with 20% indexation.
The net asset value (NAV) of such funds varies with adjustments to interest rates. Moreover, an exit load is applicable when the money is withdrawn from money market mutual funds. The risks that these funds carry - interest rate and credit risks - are akin to those of debt funds. Keeping in mind all these factors, investors can allocate a part of their investment capital to money market funds and reap the rewards.
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