Overnight funds: Ideal for systematic transfer plans of risk-averse investors

Dhuraivel Gunasekaran

A Systematic Transfer Plan (STP) is often the preferred way to invest in an uncertain equity market such as the present one. You invest a lump-sum amount in a debt fund and then give an instruction for transferring a fixed sum every day, week or month to an equity fund of your choice. The debt and equity schemes must be from the same fund house. So, which type of debt fund should you opt for?

Most fund houses offer a bouquet. From the most conservative overnight and liquid funds to slightly risky ones such as short-term bond schemes, several options are available. Liquid, ultra short duration, low duration and money market funds are of relatively low-risk low-return profiles. However, a few of the schemes in these categories take extra risk by investing a certain portion of their AUM (assets under management) in papers rated AA and lower.

For risk-averse investors

But ultra conservative investors who don’t want to take credit risk can consider overnight funds.

The overnight funds category generates moderate returns commensurate with relatively low risk and higher liquidity, and are preferred over savings bank accounts, and liquid and arbitrage mutual funds.

Lakshmi Iyer, President and Chief Investment Officer (Debt) & Head Products, Kotak Mahindra AMC explains, “Overnight funds invest largely in TREPS (which is a secured form of overnight lending) and hence the credit and interest rate risks are mitigated to a large extent. These funds can also invest in one-day residual maturity debt instruments within the current framework.”

TREPS (Tri-party Repo) is a very short-term debt instrument. A participant in TREPS can borrow and lend for the short term (one day to a year) by using government securities and corporate bonds as underlying collaterals. Overnight funds participate as lenders in TREPS.

Overnight funds carry very low credit risk as the default risk in the TREP transactions is very low. Counter-party risk is minimal. The underlying collateral securities are mostly G-Secs. Since these transactions mature within a day, they eliminate interest rate risks too.

In the current falling interest rate scenario, overnight funds generate similar return to that of liquid schemes. Overnight funds also score over other short-term debt funds with a lower expense ratio and almost nil credit and rate risks.

The average expense ratio of the regular plans of overnight funds as of September 2020 was 0.18 percent, which is lower than the 0.3 percent charged by liquid funds and 0.77 percent of ultra-short-duration funds.

Falling return in liquid funds

Rahul Goswami, CIO- Fixed Income, ICICI Pru AMC says, “RBI’s focus on supporting the economy in a negative growth environment resulted in reduction of policy rates by 115 bps in CY 2020. Also, to spur demand and to protect the weaker segment of the economy from COVID-19 pandemic disruption, RBI continues to keep policy stance accommodative and maintain surplus liquidity conditions.

Liquid schemes invest in short money market instruments (MMI), which tend to react strongly towards RBI policy rate and liquidity conditions; both the factors were conducive for MMI rates coming down sharply, which subsequently resulted in a fall in the YTM (yield-to-maturity) of liquid schemes”.

“This is more pronounced at the very short end of the curve where rates are tending to mirror reverse repos rate,” Lakshmi Iyer points out.

True to this, most of the short-term rates are below the reverse repo rate of 3.35 percent. For instance, the rate of TREPS (Tri-party Repo), Repo rate, 91-day T-Bill stood at 3.04 percent, 3.08 percent and 3.19 percent, respectively. Rates on Certificates of Deposits (CDs) and Commercial papers (CPs) too traded at lower levels of 3.25 and 3.4 percent as on October 25.

This has led to a fall in the returns of liquid funds. The average three-month annualised return of regular plans of liquid funds was 3.24 percent. Meanwhile, overnight funds delivered 3 per cent during the same period.

Will this trend continue?

“Such an accommodative stance of the RBI may keep the short term rates depressed for some time until the economy finds its feet” expects Rahul Goswami.

That is what makes overnight funds more attractive for STPs, as they generate returns that are more or less similar to those of liquid funds, and yet come with lower cost..

Though institutions are the major participants in overnight funds, ultra-conservative investors can consider these schemes to park their emergency corpus. Normally, investors can redeem proceeds from overnight funds on the next business day (T+1 basis). Overnight funds can be a source scheme for STP transactions.

Note that under the growth plan in overnight funds, selling units within 36 months attracts short-term capital gain tax, according to the investor’s slab. For investors in the lower tax brackets, the dividend reinvestment plan works better as dividends are taxed at your income-tax rates and get reinvested in the scheme.