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A one-night stand that is safe for retail investors

Overnight debt funds offer the highest level of protection and liquidity

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In a gap of just two months, fund houses have rushed in to file offer documents for overnight funds, a class of debt schemes that has shone to prominence after many schemes were found to be exposed to the IL&FS saga. This proved to be the veritable Achilles heel after the financial institution witnessed multiple defaults and triggered a scare in fixed income markets that is reminiscent of the 2013 taper tantrum. Liquid funds, a popular category, faced a crisis of confidence, and this is where overnight funds, a safer cousin, came to light. Since overnight funds necessarily have to invest only in securities maturing in a day, these funds offer the highest level of protection and liquidity for those parking their short-term surpluses, experts tell DNA Money.

Suitable for retail

Overnight funds, as the name suggests, invest in securities having a maturity of one-day. Generally they invest in collateralised borrowing and lending obligations (CBLO) and repo/reverse repo instruments that mature the next day. Such investments do not incur an interest rate risk or credit risk as compared to other debt schemes. Aditya Bajaj, Head - Investments, BankBazaar.com says that overnight funds are suitable for retail investors as far as risk is concerned.

"They are meant for corporate treasury money but nothing prevents a retail investor from investing in them. If a retail investor is holding large sum of money for very short period - one week or 10 days - this may be suitable," argues Vidya Bala, Head, Mutual Fund Research, FundsIndia.

So, retail investors looking for highest level of capital protection and liquidity can consider overnight funds for parking their short-term surpluses, advises Manish Kothari - Director & Head of Mutual Funds, Paisabazaar.com.

However, Kaustubh Belapurkar, Director Manager Research, Morningstar feels that retail investors typically will not be looking at such short-term parking of funds. Retail investors would be better off investing into ultra-short duration and low duration funds for short-term parking of funds, he says.

Rush for one-nighters

In a matter of two months, AMCs including Aditya Birla Sun Life, ICICI Prudential, Reliance, IDFC, Kotak, and DSP have filed offer documents for their overnight funds. Apart from investor demand, there is another reason. After Securities and Exchange Board of India' norms on the categorisation and rationalisation of mutual funds, overnight funds as a category remains under-penetrated.

"From the 40-odd fund houses, we have only six schemes in the category, of which, two schemes were launched in November 2018. It was expected that MFs would launch schemes in categories where they were not present. Hence, there has been a flourish of New Fund Offers over the past few months, as fund houses were filing in the gaps," says Jason Monteiro, AVP - Mutual Funds Research & Content, Prabhudas Lilladher.

Overnight funds may take a share of flows from liquid funds. Bajaj of BankBazaar.com says that if an investor invests today and redeems tomorrow, an overnight fund will easily manage the liquidity. While a liquid fund also manages to honour the redemption, if all investors come to redeem, it might be difficult since funds may be invested in securities maturing in more than 1 day (allowed to invest in securities up to 91 days).

Overnight funds are increasingly seen as the preferred choice for retail investors following the volatility of returns in liquid funds. "Until recently, liquid funds were the preferred category for retail investors for their liquidity needs due to easy liquidity and high safety of capital. This is because the short tenure of the liquid fund portfolio is not impacted by the broader market fluctuations. However, certain liquid funds started taking higher credit risk in their portfolios to enhance returns. This led to higher volatility and in some cases liquid funds saw a fall of as much as 7% of their NAV in a single day," pointed out J C Gougeon, Director, Sharekhan by BNP Paribas.

Factors to consider

Overnight is less volatile than liquid funds as well. "As per the current practice, liquid funds value their underlying securities using prices arrived by rating agencies for securities that have maturities of less than 60 days, and mark-to-market securities with a higher residual maturity. Hence, the volatility in returns will be higher for liquid funds," said Monteiro.

Regulations are silent on the amount of credit risk that liquid funds can take. As a result, in the past, few liquid funds have invested in low credit quality securities to generate higher returns and thereby, compromised with the capital safety of investors, said Kothari of Paisabazaar.

Remember that the higher level of capital protection and liquidity in overnight funds comes with lower returns. Their annualised returns would be lower than liquid funds, but higher than savings accounts. Thus, only those who prioritise capital protection and liquidity over the rate of returns should opt for overnight funds.

Given the extremely short maturity and risk, the returns of overnight funds is lower at around 5.5%-6% for the past 1-year. In comparison, liquid funds as a category have generated a return of over 7%.

An investor who wishes to invest in overnight funds should check how the fund has performed in the recent past and opt for a fund with a low expense ratio, said Monteiro.

Taxation in overnight funds would be like other debt funds. This means long-term capital gains (LTCG) tax is 20% (plus surcharge, if applicable and cess) with indexation if units are held for more than 36 months and short-term capital gains (STCG) tax is at the income tax slab rate if units are held for less than 36 months.

SECURE AND LIQUID RETURNS

  • Overnight funds offer higher level of capital protection and liquidity in as compared to liquid funds, but lower returns.
     
  • The returns are 5.5-6% as compared to 7% returns offered by liquid funds
     
  • Suitable for investors who want to invest a lumpsum amount for very short periods, say a week or 10 days
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