Overnight Funds

Overnight funds are debt funds that invest in overnight assets, or securities with a residual maturity of one day. This is a new category of debt funds that was introduced as part of SEBI's mutual fund reclassification exercise in 2018.

To understand how Overnight Funds work, you need to know where they invest and how they generate returns.

• Where do Overnight Funds Invest:

  Overnight funds invest in CBLOs, overnight reverse repos, and other debt or money market securities that mature in one day. This is in keeping with SEBI norms, which requires them to invest only in assets with overnight maturity. The entire asset holding of an overnight fund can be classified as "Cash and Cash Equivalents". The portfolio of an overnight fund is replaced every day with new overnight securities. Overnight schemes are not permitted to invest in deposits or specified risky debt instruments; this rule aims to reduce the risk of default in their bond portfolio.

• Sources of Earnings:

  Overnight funds earn only through interest payments on their debt holdings. There is no scope for earning capital gains as the securities held by the fund mature in one day. In fact, returns of overnight funds reflect overnight lending and borrowing rates. When interest rates are falling, and short-term liquidity is abundant, overnight rates in the money market decline. When interest rates are rising, and market liquidity is tight, overnight rates increase. Thus, returns of overnight funds are closely linked to rates and conditions in the overnight market for funds.

• Safest Debt Fund:

  Overnight funds are the safest among debt funds, with zero interest rate risk and minimum credit risk. Let us understand this in some detail.
  Since overnight funds invest in overnight securities only, there is no chance of making capital gains or losses. The value of the fund does not show volatility but increases slowly due to interest income. Overnight funds have near-zero credit risk too‐ as it is highly unlikely for securities maturing in one day to default on interest payments. In summary, compared to liquid funds (which is the debt fund category closest in risk-return terms), overnight funds are relatively safer.

• Low cost:

  Overnight funds are low-cost debt funds, mainly because their debt holdings are not managed actively. In practice, most overnight funds operate with expense ratios below 1%.

• Flexible holding period:

  An investor in an overnight fund can hold his or her investment for as long as necessary. It is easy to enter and exit the investment while earning safe, market‐linked returns for the duration of the investment.

• Investors with a very short investment horizon:

  Overnight funds are ideal for those with an investment horizon of one week or less, as investors can redeem after holding the units for even one day. This flexibility is a big advantage of overnight funds over liquid funds, which now charge an exit load for redemptions within seven days.

• Medium to Route investments in Equity Funds:

  Investors who do not want to take any risks until they move to equity can hold funds in an overnight fund. From these funds, investors can use an STP to route investments systematically into an equity fund. This allows them to invest in equity over time while ensuring that the corpus is held safely held in the overnight fund.

Overnight funds are the safest category of debt funds available. However, investors must keep in mind some fund features before investing.

First, overnight funds are not designed to optimize returns. Instead, they are akin to a savings account, in the sense that the investment is safe and can be readily withdrawn. Thus, overnight funds as a category tend to offer relatively low returns.

However, there is a fair amount of variation among the different funds in the market in terms of returns as well as expense ratios. Hence investors should carefully analyze the market and pick out the funds with a consistent record of good performance and low cost.

Second, investors in overnight funds have to compromise on returns in exchange for safety and liquidity. Therefore, investment in an overnight fund should be consistent with the investor's financial goals and strategy, and not merely a reaction to recent episodes of credit default.

For example, while it is a good idea to allocate some money to an overnight fund; it may not be smart to shift entirely to overnight funds, simply to avoid risk. If the risk appetite of an investor is low, but his or her investment horizon is longer (say 3‐6 months), more returns can be earned by investing in liquid funds or ultra-short duration funds that hold high-quality bonds.

Investors earn dividend income and capital gains from overnight funds. Dividend income is not taxed in the hands of investors. Capital gain is the difference between the purchase price and the selling price of the units. The rate of tax on capital gains depends on the time for which the investor holds the units of the overnight fund.

• Short term Capital Gains Tax:

  If an investor stays invested for a period of up to 3 years, capital gains are considered as short-term capital gains and taxed at the income tax slab rate applicable to the investor.

• Long term Capital Gains Tax:

  If an investor sells the units of an overnight fund after holding it for longer than 3 years, it is considered as long-term capital gain, and the investor gets the benefit of "indexation." This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. In other words, the taxable amount is reduced due to indexation. Long term capital gains are currently taxed at a lower rate of 20%.

In evaluating overnight funds, two criteria are commonly used: returns and expense ratio. Since overnight funds invest in securities that mature overnight, their performance should be measured on the basis of one week, or at most one-month returns.

The expense ratio is the amount that is charged by the fund annually for managing the investment portfolio. The net return to the investor is calculated after subtracting expense ratio. Hence higher expense ratios reduce the final return to the investor.

The above table shows returns and expense ratios of the top 5 overnight funds ranked based on one week and one-month returns. Note that the top funds in this category have almost identical returns; therefore, expense ratios should be a key factor in picking a fund. Also note that returns for periods shorter than one year are usually absolute returns, which means that they should be annualized if they are to be compared with other returns. For example, the one‐week return is 0.10%. This can be annualized as follows: 0.10% x (365/7) = 5.21%. The annual return is fairly close to the overnight borrowing/lending rate on that date, which was about 5.24%.

• Overnight funds are debt funds that invest in debt securities with overnight maturities.
• Overnight funds invest in reverse repo, CBLO, and other debt assets with a maturity of one day.
• Overnight funds earn through interest payments on their debt holdings. Since the funds invest in overnight securities, there is no scope for earning capital gains.
• Overnight funds are the safest debt fund. They carry zero interest rate risk and minimal credit risk.
• Overnight funds offer safety, liquidity, and flexibility of withdrawal. They have the potential to earn higher returns than bank savings deposits, especially given the tax advantages of debt funds.
• Overnight funds are most suitable for investors with a very short investment horizon or for use as a medium to route funds into other long-term funds.