19 May, 2015

Two pieces - on liquidity management & on rationalising insurance portfolios

Hoarding money in a savings account is not the only option
It is quite common to have a fat sum of money in your bank account, just for security. But this huge amount yields only about a 4 per cent return on a gross basis. It would be much less after adjusting for taxes. Is there a better way to manage liquidity requirements?
Liquid funds, flexi-deposits
It is suggested to maintain three months' expenses (including EMIs) as a liquidity margin in most cases.
But beyond a point, the margin need not be in the bank at all. For, in normal circumstances, what would get used up would be only one month’s expenses. Hence, it makes sense to keep about half the liquidity margin in the bank and the other half in a liquid/ultra short-term mutual fund scheme.
These are currently yielding around 8 per cent or more, which is significantly higher than savings bank account returns. The other possibility is investing in sweep-in deposits or flexi deposits, where what is lying to one’s credit is made into a deposit yielding higher returns after a threshold. As and when the money is required, the deposits are automatically broken and they come into the savings account. In all these, however, there is no tax advantage to be derived.
Arbitrage funds
Till the last Budget, a debt mutual fund would have been an ideal choice to help you earn more and still save taxes. But the budgetary changes have made debt funds unattractive for up to three years, as the tax arbitrage has been removed. To address this issue, there is a new knight in shining armour – arbitrage funds. These funds typically take advantage of inefficiencies in the equity market and operate in cash and derivative markets.
Often, they take advantage of positions that does not result in any real risk. Due to this, arbitrage funds can provide decent returns akin to a liquid fund, but become tax-free after a holding period of 12 months, as the underlying would be equity assets. The risk is contained in these funds, unlike in an equity fund.
In some arbitrage funds, there would be debt too. But, the equity component is maintained at 65 per cent or more to qualify for equity fund treatment in most cases. The upshot is that one can get tax-free returns from an arbitrage fund after 12 months and this can be an effective tool for needs coming up in 12-36 months.
So if provisions need to be made for upcoming short- to medium-term goals, arbitrage funds will be ideal.
In other cases, money is needed to be kept aside for a contingency, whose timing is indeterminate. For instance, one can make a contingency fund for parents who may need medical assistance in future. There is a chance that this fund may be lying around unused for a long period of time.
There can be other situations, where the event may be a certainty, but the timing is in future and not certain. In such cases, it may be a better idea to invest in medium- to long-term debt funds to take advantage of potentially long holding periods, potentially higher returns & better tax treatment (assuming a three-year holding period ).
In practice, we have even found cases where liquidity provisions made lie around for years together, unused. There is actually a case for reallocating liquid funds too, partly, into somewhat longer tenure instruments.
The other alternative
There is another effective tool available today for managing liquidity/contingencies.
This will work for people who have home loans. These are current accounts attached to home loan accounts, where one could keep the liquidity/contingency provisions.
Home loan interest will not be charged to the extent of money kept in that account. The amount in that account can be freely withdrawn, as and when required. Hence, this is a wonderful liquid pool, that is earning/saving over 10 per cent returns, depending on how you look at it.

Author : Suresh Sadagopan   |   Article published in BusinessLine on 04/01/2015

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