A fixed deposit is one of the simplest instruments to understand. However, make the FD tradeable mid duration then all sorts of complications will arise. You will lose money if you try and sell when interests increase or if the bank suffers financial trouble and drops in credit ratings. It is no secret that debt mutual funds are complicated but risk-averse investors can consider parking their money in overnight mutual funds. This is a type of debt fund with practically no interest rate fluctuation risk and credit rating risk and low credit default risk.
As a student, I love debt mutual funds because of the above-mentioned complexities and regular readers may be aware that there is exclusive category available with as many as 47 posts. The essential posts have been combined into a Free E-book: A Beginner’s Guide To Investing in Debt Mutual Funds. Even those who do not know what a debt mutual fund is can use the book to start investing. Note: All of us will need debt mutual funds when we retire even if we do not want to or have no need for them now. So it is important to learn more. Why? Because you can smartly reduce Tax with Partial Mutual Fund Withdrawals( Examples + Calculator)
Before this post, I had created a poll at FB group Asan Ideas for Wealth: “Will you park money (not invest) in a liquid mutual fund that has practically no interest rate fluctuation risk and pretty low credit default risk? This means you will only get a little more return than SB account. This money can be part of your emergency fund or just money that you want to keep aside for a while for whatever reason without worrying about gains. This is with reg to my next post. Curious how many will be interested in such an option. Not implying that this is a good or the best option. Just curious about risk-reward sentiment here.”
Yes: 329 votes and No: 129 votes. Most people who disagreed believed that a high-interest SB account or a flex-deposit SB+FD account is better than an overnight mutual fund. I agree that bank accounts will work for small sums. As long as you get 10K interest income free from an SB account and that too at around 6%, why would you look elsewhere?
Overnight mutual funds can be useful for those with a reasonably large corpus. Maybe an emergency fund, maybe part of your medical expenses fund. Maybe you want to time the market. The point is that those who have made partial withdrawals from a debt fund (now equity fund) will attest that the taxation is low even if you have to pay as per slab as there is no concept of interest (see above post).
Please do note that the risk in an overnight mutual fund is lower than a typical liquid fund. So this means the return will be a bit low. Of course, star rating guys will compare apples with tomatoes because they are red in colour and offer lower stars to overnight mutual funds. The stupidity behind that is obvious. I have already discussed this point and how to spot overnight mutual funds in this post: How to Choose a Liquid Mutual Fund. With all that out of the way, let get to it.
What is an overnight mutual fund?
It is a debt mutual fund that invests in bonds that mature in one day! So at the start of each business day, the entire AUM would be in cash, overnight bonds would be purchased, they will mature the next business day, the fund manager would take the cash and buy more overnight bonds and so on. So each the NAV increase just a little bit due to the interest income. Does that crazy to you? Probably, but it is not without benefits.
If a bond matures the next business day, it price will not be affected if RBI changes the (overnight) interest rate. Next day, your bonds mature and you will buy new overnight bonds at the new rate.If the credit rating of the bond issuer changes, the bond price will not be affected as your bond will mature the next day. You are in trouble only if the issuer absconds with your money or refuses to pay up: credit default risk. To handle this, the agency that organises the transaction get collateral (security) from the bond issuer. So that default risk is also taken care off (not 100%, but more than reasonably).
Why would an issuer offer an overnight loan? Because the government or large corporations may need excess cash for a day. So they borrow. Next day, they check again. If they have excess cash, they will lend to other companies. Else they will borrow again. Naturally, the interest rate would be pretty low. But then again if you want safety and peaceful sleep, you got to a pay a price.
Please note that prior to SEBI categorization rules, overnight funds were called cash funds, or cash management funds etc. So this is a sub-category of liquid funds.
Where do overnight mutual funds invest?
Their most popular choice of bond is a Collateralized Borrowing and Lending Obligation (CBLO). This is run by the clearing corporation of India – CCIL The corporation seeks collateral from bond issuers to mitigate risks as the “repayment of borrowing under CBLO Segment is guaranteed by CCIL” (see) The collateral itself is a short-term government bond. Since the value of the collateral will fluctuate on a daily basis due to market forces, CCIL will demand an amount proportional to the fall in value from the issuer to cover their losses. Members of CCIL-CBLO segment also have an obligation to lend. Even within that one day, some bonds will have a put and call option. That is, the bond buyer can ask the issuer to pay back mid-term (put option) or the bond issuer can payback on their own mid-term (call option). All this is, of course, a simplistic depiction of what happens. So experts kindly bear with me.
Just to reiterate, bond price due to interest rate movements and credit rating changes are practically non-existent in an overnight bond. Default risk is minimised due to a great extent due to the presence of collateral, a guarantee by the clearing corporation (because of the collateral) and the fact that the tenure is just one business day. The major risk in an overnight fund is reinvestment risk. If rates keep falling then the fund will have lower and lower return. Of course, this risk is present in any accrual based fund. You can expect 5-6% from this fund as per current rate scenario.
Overnight mutual funds can also invest in reverse repos – a money market instrument where you sell the bond back to the issuer at a higher price or any other bond with overnight maturity. After reading this, I would bet that many of the 329 voters who said “yes they would choose such a fund” will change their mind! You might be thinking why go into so much trouble. Well it is a sm
Examples of overnight mutual funds
1 HDFC Cash Management Fund – Call Plan – new name: HDFC Overnight Fund. It will now be a pure overnight fund investing mainly in CBLOs.
2 L&T Cash fund – now will be an overnight fund.
3 UTI G-Sec Fund will now become UTI overnight fund.
4 SBI Magnum InstaCash Fund – Liquid Floater will now become SBI Overnight Fund
Please note that there are differences in the investment strategies of each fund. While the objective would be to predominantly invest in overnight securities some of them can use derivatives (debt arbitrage), invest in uncollateralized corporate overnight bonds etc. So please read the scheme documents linked above if you are interested.
Who should choose overnight funds?
Anyone who wants to park money with the least amount of risk without worrying about returns. Anyone who will not be needing a big lump sum in one shot and likely to make partial withdrawals.
So what you think? Will you consider such liquid funds? Or will you stick to bank deposits or take a bit more risk with ultra-short term funds or use only arbitrage to minimize tax out go?
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