What are Overnight Funds?

8 Sep 2021  Read 709 Views

What if we said you could have a low-risk and less volatile debt mutual fund that could be converted into cash within a day or so? Liquid funds, you ask? No No, even more liquid than liquid funds are these Overnight Funds!

Before starting today’s discourse on overnight funds, let’s briefly re-revise the working of a debt mutual fund. So, what happens in a debt mutual fund is that you are an investor who invests in a mutual fund via SIP or lumpsum investment and the mutual fund invests your money in debt instruments like bonds and debentures.

Though there are already varieties of debt mutual funds in the market depending upon the maturity of the underlying debt, to align with the demands of ultra risk-averse and high liquidity demanding investors, mutual fund houses started rolling out ‘Overnight Funds’. To understand the crux of Overnight Funds, read this article.

Meaning of an Overnight Fund

An overnight fund is a type of debt mutual fund where investors’ money is parked into various money market instruments which have a maturity of just 1 day. It is an open-ended mutual fund scheme by virtue of which an investor can quickly put and withdraw their money whenever they wish to.

So here, a mutual fund house receives the fund from investors, holds the sum at the start of the business day, and then goes on to invest or lend this money to big corporations who promise to return the principal along with interest in just 1 day. This makes interest a source of income for investors and eliminates the possibility of adverse effects due to change in interest rates, credit risks, and loss on an investment due to high exit loads or expense ratios.

Participants in an Overnight Fund transaction

What you need to keep in mind is that there are four main participants in this sphere:

  1. Lenders - These are the investors in overnight funds, who may be retail investors, institutional investors, banks, and other institutions.

  2. Mutual Fund house -  This is an overnight mutual fund in which people have invested, and the fund is ready to lend this sum at some predetermined rate of interest.

  3. Borrower - A market is never complete if there isn’t a person or institution ready to perform an action opposite to yours. In the case of overnight funds, one of the primary borrowers is a bank.

Now, before we move ahead, here’s a question: when you buy shares in the stock market, are you aware of the seller? No, right? You are happy executing your move with the hope that there is someone who is of a different opinion and is ready to provide you the desired share at the desired price. This is where the third participant comes in:

  1. CCIL - Since you don’t know the seller in person, there is a clearing and settlement house in stock markets which ensures that the security is delivered to you and the money is delivered to the seller. In the case of Overnight Funds, The Clearing Corporation of India Limited is responsible for the matchmaking of lender and borrower and even for the settlement of transactions overnight.

Why should you invest in Overnight Funds?

  1. Liquidity

These funds are highly liquid as the invested funds are not lent for an extended period of time in addition to the one-day short residual maturity of invested securities.

  1. Low-risk factor

Investors who tend to possess a low-risk appetite can invest in overnight funds as many risks like that of credit or default are mitigated by a short period of lending.

  1. Less volatility

The tenor or maturity period of bonds plays a crucial role in the valuation of bonds alongside the movement of interest rates in the macroeconomic environment. Since these bonds mature in just a day, they have very little exposure to these factors, which makes it an even safer option to invest in.

All of the aforementioned factors make overnight funds a worthwhile and profitable deal as it offers safety, security, sustainability and apt returns for a conservative investor.

Why should you not invest in Overnight Funds?

The most cardinal reason because of which investors should refrain from investing in overnight funds is that although the returns from overnight funds come without downside risk, one has to part ways with inflation-beating returns most-of-the-times as compensation towards high safety and liquidity features of this investment avenue.

Taxation of Overnight Funds

As overnight funds fall under the category of debt funds, they are also taxed in a similar manner.

  1. Short Term Capital Gains (STCG) - If an investment in overnight funds is held for less than 36 months, the investor is subject to pay tax as per the tax slab they fall under. 

  2. Long Term Capital Gains (LTCG) - If an investment in overnight funds is held for more than 36 months, the investor has to pay 20% as tax with indexation benefit (a method of adjusting purchase price to inflation). While in the case of funds that do not offer indexation benefits, investors are liable to pay a tax of 10%.

Top-performing Overnight Funds

According to the rankings published by ET Money, some of the best overnight funds for the year 2021 are as follows -  

  1. L&T Overnight Fund

  2. UTI Overnight Fund

  3. HDFC Overnight Fund

  4. SBI Overnight Fund

Conclusion

Investing in overnight funds is effortless yet beneficial! However, an investor needs to be cautious and should not invest all of what they have due to extreme safety and liquidity features of this scheme. Overnight funds can be brought into the portfolio to enhance the effect of previously mentioned factors, but they shouldn’t be in the driving seat.

All we have to say is that an overnight fund is neither a route to overnight success nor a reason for overnight failure as both of these outcomes solely depend on ‘how are you using them to achieve your financial goals?’ Therefore, as an investor, make sure not to park your funds in a particular scheme or even in a stock because of its enticing characteristics. Do check if these ‘so-good’ features resonate with your investment objective, investment horizon and risk appetite, and only then make your call.

Happy Investing!

About the Author: Prabudh Mishra | 12 Post(s)

Prabudh Mishra is a finance and behavioral economics enthusiast. He has a sense of purpose to eliminate irrationality in human behavior while they make the most crucial financial decisions in their life.

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