Overnight funds: Features, Benefits, & Investing

6 mins read

Overnight funds are a variation of liquid funds with some investor-friendly features. Because of the recent poor performance of liquid funds, overnight funds have become quite popular, and there is a noticeable shift in debt-based securities towards the latter.

What is an overnight mutual fund? According to the definition by SEBI, these are debt funds to park surplus funds for a short duration. Simply put, these are highly liquid debt funds designed to offer higher returns with initial investment protection.

Investors need to forward buy and redemption orders of their choice of funds at the exchange during trading hours. At the beginning of each business day, the fund manager uses cash to buy debt securities that mature the following day. He then uses the money to buy more overnight debt instruments, and the cycle continues.

Intention of overnight funds

Overnight funds intend to offer investors an ideal way to use their cash reserves and earn profit. Following are the most significant characteristics of overnight funds which allow it to achieve its purpose.

  • Short investment tenure: The overnight funds have a maturity of one night. The brief investment tenure allows investors to utilise their cash reserves in a better way.
  • Low-risk: short investment horizon and shorter maturity period limit the fund’s exposure to risks arising from interest rate changes in the market.
  • High liquidity: These funds are the most liquid investment option, allowing investors to use surplus corpus profitably.

How do overnight funds work?

To understand how these funds work and whether to invest, you need to know where they invest and how they generate income overnight.

Investment: Overnight funds invest in CBLOs, overnight reverse repos, and other debt instruments with one-day maturity. It is in line with SEBI’s guidelines which requires these funds to invest only on securities with overnight maturities. The entire holding is classified as “cash and cash equivalents”. The portfolio of overnight funds gets replaced every day with new overnight securities. SEBI bars overnight funds from investing in risky debt instruments to limit risk exposure and chances of default.

Source of earning: Interest earned from the debt instruments is the only source of income for the overnight funds. Since these funds invest in debt instruments that mature overnight, there is no scope for capital gains. The return on the overnight funds reflects the overnight lending rate. When interest rates are falling, and short-term liquidity rises, the return on overnight funds declines. Conversely, when interest rates are rising, returns from overnight funds rise. Hence, the returns on these funds are closely linked to the interest rate regime.

Primary advantages

Overnight funds suit investors who want to invest their money for a short period (overnight). Since the investment period is short, these funds don’t get affected by changes in the interest rate and hence, are a safe form of debt mutual fund. Besides, there are a few more advantages of investing in these funds.

Better utilization of idle funds: These funds are ideal for investors who temporarily park their idle cash for better returns. Unlike bank deposits with extended tenure, these funds allow investors to generate higher returns at a shorter period.

Low-risk: These are open-ended mutual funds that come with low risk. This particular feature makes it desirable to low-risk investors and individuals with a conservative outlook towards investment. Because of the short investment, these funds are not exposed to risks caused by changes in interest rates.

Protection against market volatility: Other debt funds run the risk of changes in the rate of interest in the market due to longer investment horizons or due to the changes in the credit rating of the issuers. But overnight nights are shielded from such changes. The portfolio of overnight funds changes every day and safeguards investors against risks of interest rate fluctuations, uncertain liquidity, and credit risk.

Easy liquidity: There is no entry or exit load, which further reduces investing costs and makes these funds highly liquid. Investors can withdraw their investment at any time during an emergency.

Things to consider before investing

Overnight funds are one of the safest forms of mutual fund investment. But investors considering investing in these funds must keep the following factors in mind.

Returns: Overnight funds are not designed to produce optimum returns. Instead, these function like savings accounts offering security to the principal and liquidity. Hence, returns from overnight funds are relatively less than other investment alternatives.

Fund managers of these funds compromise returns to ensure safety and liquidity. Hence, shifting the entire investment into overnight funds is not a good idea, especially with long-term financial goals. These funds can help you avoid risks to some extent, but to earn higher returns, you will have to spend time in the market. If you want to invest for 3-6 months, liquid and ultra-short duration funds will offer better returns with high-quality bonds.

Lastly, investing in overnight funds should align with your overall financial goal and strategy rather than a knee-jerk reaction to recent episodes of credit default. It is more of a solution to protect initial capital and enjoy high liquidity on your idle fund.

Who should invest?

Ideally, anyone can invest in overnight funds, but here are a few things to consider.

When you have a very short investment horizon: Overnight funds fit investors with short-term investment goals, maybe a week or less. These allow investors to redeem their units even after holding them for a day. This flexibility gives overnight funds an advantage over liquid funds, which now can charge exit fees when investors withdraw.

Medium for Routing investment: Investors can set up a gradual shifting of their capital and park their investable funds temporarily in overnight funds to earn higher returns and safeguard their principal amount.

Taxation on overnight mutual funds

Investors can earn from dividend payments and capital gains from overnight funds. Capital gain is the difference between the purchase price and selling price at the time of redemption. The tax rate applies depending on the tenure of investment.

Short-time capital gain: If an investor stays invested for less than three years, a short-time capital gain tax will apply to the capital appreciation value. The amount is added to the income of the investor and taxed per income tax slabs.

Long-term capital gain: If an investor redeems an overnight mutual fund after holding it for more than three years, long-term capital gain tax will get levied at the rate of 20% with benefits of indexation.

Indexation is a process of adjusting the purchasing price with the changed inflation rate. It allows investors to lower their tax burden.

How to find the best overnight fund for investing

Finding any investment option demands extensive research and understanding of one’s financial objectives. The selection of overnight funds depends primarily on two factors – returns and expense ratio.

Since overnight funds invest in debt securities with a shorter maturity, their returns are measured on a timeframe of one week, or at most over a month.

The expense ratio is an amount charged by the asset management company annually for managing the funds. Since net returns for investors are calculated after subtracting the expense ratio, a higher expense ratio lowers absolute returns.

Key takeaways

  • Overnight funds are short duration mutual funds with high liquidity
  • After the recent poor performance of liquid funds, there is a prominent shift in debt securities to overnight funds
  • These funds invest in a reverse repo, CBLO, and other debt securities with overnight maturity
  • These funds are open-ended debt funds invested in low-risk securities that mature overnight
  • These appeal to low-risk investors and individuals with conservative outlooks
  • Overnight funds carry low risk caused by the changing interest rate and, therefore, are safe
  • These funds protect principal by investing in debt securities
  • Investors select the best overnight fund based on its returns and expense ratio
  • The capital gain tax applies to the capital appreciation value depending on the duration of the investment
  • Investors use overnight funds to park excess corpus for better returns before transferring to equity investment

Now that you have learned about overnight funds choose the best overnight fund from the market.

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Can ultra-conservative investors invest in overnight funds?

Considering these funds invest in debt securities that mature overnight, these are suitable for ultra-conservative investors. Because of the short investment tenure, these are not exposed to risks arising from interest rate change.

Is it safe to invest in overnight funds?

Overnight funds are one of the safest forms of mutual funds investment. Their low investment duration and high-quality borrowers make these funds safe for investing.

What is the minimum amount that I need to invest?

The minimum investment amount will vary between the companies, but most allow investors to start investing with Rs 1000.

What is the minimum amount that I can redeem in overnight funds?

There is no minimum threshold. One can redeem any number of units or amounts.