Liquid funds have taken a hit, but don’t replace them with overnight funds

  • Liquid funds holding securities with the highest credit quality will still earn better returns than overnight funds
  • Overnight funds cater to the need for a liquid investment with negligible risk for investors looking to park their funds for very short periods of time

Until recently, liquid funds were seen as an alternative to the savings bank account. But they took a hit after the emergence of poor quality bonds in the portfolio of some of these funds leading to a fall in their net asset values (NAVs). The returns or NAVs of these schemes are expected to be more volatile and shrink further, given the recent revision in the debt valuation norms by the Securities and Exchange Board of India (Sebi).

Investors looking for an alternative to liquid funds now seem to have turned their attention to overnight funds that can give the security and liquidity of a savings bank account along with better returns. However, before you consider these schemes, it is important to understand the risk and returns in this category of funds.

Risk and return

Overnight funds cater to the need for a liquid investment with negligible risk for investors looking to park their funds for very short periods of time. The return is not the driving factor in these funds and the portfolio is structured for liquidity and safety so that investors can redeem their money at short notice without any risk of losing value in the capital parked.

Overnight funds stay clear of the two primary risks in debt funds. These are the risk of volatility in the values of the securities in the portfolio in response to changes in interest rates in the market and the risk of default in receiving interest and principal from a deterioration in the credit worthiness of the issuers of the securities who may now be unable to meet their obligations. Both these may lead to the fund making a loss.

As the name suggests, overnight funds invest in debt instruments with one day to maturity. When the bonds mature, the fund reinvests the proceeds in the next set of one-day instruments. The risk from default or fall in value within a day is negligible. Typically, the funds invest in collateralized borrowing and lending agreements (CBLO), a short-term borrowing facility backed by securities of the central government through which mutual funds lend to banks and others, and reverse repos. Both of these are protected from credit risk since they are backed by collateral securities. The schemes may also invest in money market instruments such as treasury bills, certificates of deposit and commercial papers with residual maturity of not more than a day. If the interest rate for the day is high, the returns from overnight funds are up and vice-versa, with no impact on the value of the securities.

The returns from overnight funds, thus, reflect the overnight rates for lending and borrowing in the market. Since all overnight funds invest in securities with the same tenor—one day to maturity—the returns are in a tight range across all schemes. The one-month returns from the overnight category as on 15 March 2019 were in the range of 0.46-0.48% and the quarterly return was 1.52-1.54%. The outlier is the L&T Cash Fund with lower returns of 0.42% and 1.38%, respectively, for the two periods mentioned above, and that can be attributed to the higher expense ratio, the fee a mutual fund charges, of 0.80% as compared to around 0.20% for most funds in the category.

There may be variations in the type of securities held in the portfolio, with some schemes investing in derivates, securitized debt and repo in corporate debt. “We believe that most overnight funds are using only overnight instruments like CBLO, repo, corporate bond repos. Repos in corporate bond securities are backed by AAA-rated PSU bonds with a reasonable haircut and all the risks are mapped in, so there isn’t any additional risks in the portfolio," said Devang Shah, deputy head, fixed income, Axis Mutual Fund.

What should you do?

Overnight funds currently cater to institutional investors looking to park money for extremely short periods with negligible risk.

“Overnight funds became fashionable when there was a crisis in the liquid funds category on account of the quality of the portfolios of some schemes and for a brief time there was interest in the overnight funds from retail investors. We still believe that liquid funds are comparable in terms of safety, and with the mark-to-market corrections that have come about, we find that there is adequate safety in liquid funds and we are not looking to move money to overnight funds," said Shyam Sunder, managing director and co-founder at PeakAlpha Investment Services Pvt. Ltd, a financial planning firm.

Liquid funds are expected to bring down the maturity of the securities held by them to avoid the volatility in NAV that comes from marking to market. “The returns from liquid funds are expected to fall from current levels due to change in valuation norms of debt securities as maturity of liquid funds will fall from 45-50 days to 25-30 days," said Shah.

Liquid funds holding securities with the highest credit quality will still earn better returns than overnight funds given that they hold securities with 25-30 days to maturity, while overnight funds hold them only for a day. And with many liquid funds allowing investors to withdraw up to 50,000 instantly, and offering useful online features, liquid funds should continue to be the choice for retail investors looking for a steady short-term ride.