Rising Interest Rates – Right Time to Start Investing in Overnight Funds?

Since the RBI announcement on the repo rate increase, overnight funds, considered being one of the safest debt mutual fund categories, are seeing a fresh influx of investors. As the stock market continues to give mixed signals about bullish trends and interest rates expected to rise further, investors are starting to park their money in overnight funds. 

As the demand for overnight funds is on a rise, many investors would like to know if this is the right investment avenue in current times. Here, we will try to address this question and talk about the benefits plus aspects to keep in mind before investing in these funds.

What are overnight funds?

Overnight funds are debt mutual funds that invest in assets with overnight maturity. This category of debt funds was introduced in 2018 and has since gained popularity among debt fund investors.

Some of the securities that these funds invest in include:

• Reverse repos
• Collateralized Borrowing and Lending Obligation (CBLOs),
• Other debt securities with one-day maturity

The funds follow a short investment horizon and are therefore sought-after by corporates who would like to park their funds for a day to gain some returns instead of retaining in current accounts. 

What do the statistics say about rising demand for overnight funds?

The stock market downfall has been visible since October 2021. This is also the timeline when investors are seen to be shifting towards overnight funds to park excess funds. As per a report published by ET, the number of schemes in the overnight fund category jumped up from 1.55 lakh in October 2021 to 5.85 lakh currently. 

Today, the average assets under management (AUM) of these schemes combined have risen to Rs. 1.36 lakh crores. As against, the overall debt mutual fund AUM dropped to Rs. 13.62 lakh crores during this period.

Source : Livemint

Benefits of investing in overnight funds

Since overnight fund returns move in sync with repo rates, investors are better off investing in these debt funds as compared to other funds. Some of the other benefits offered by these funds are:

1. Safety: Overnight funds are considered the safest debt funds as they pose negligible interest rate risk and low credit risk. The near-zero credit risk is mainly because the funds invest in securities with one-day maturity and therefore, the chances of default are low.
2. Low cost: Since the debt holdings of these funds are not actively managed, most overnight funds have expense ratios lower than 1%.
3. Liquidity: Due to the short-term investment holding period, these funds offer high liquidity.
4. Flexibility: Overnight funds allow investors to hold the investment as long as needed. Also, entering and exiting the investment is easy.

Important points to note before investing in overnight funds

Although overnight funds are the talk of the town lately, investors must note the following points before investing in them:

• Check for optimal returns – These funds are not capable of optimizing returns. They are more like a bank savings account where the objective is to keep the funds safe and ensure liquidity. Thus, these funds may offer relatively low returns except when interest rates are on a rise. Since different funds offer different returns and charge different expense ratios, investors must analyze and compare funds before picking the right fund for investment. It is ideal to go by a consistent performance track record and low-cost combination.
• Align with objectives – Investing in an overnight fund should align with an investor’s financial goals. So, one can allocate a portion of available money to an overnight fund instead of placing the majority amount for the sake of high interest rates.
• Investment horizon – Investors who have a low risk-appetite but a longer investment horizon are better off investing in liquid or ultra-short duration funds that offer higher returns from high-quality bond investments.

Identifying the right overnight fund for investment during current scenario

Investors who are looking to invest in an overnight fund to benefit from the current interest rate hike, here are two criteria that can be used for short listing the right funds: 

1. Returns – The performance of overnight funds should be assessed on shorter timelines, like one week or one month. Thus, while short listing a fund, an investor can compare various fund returns for these timelines.
2. Expense ratio – The amount charged by the fund house for actively managing the portfolio is known as the expense ratio. An investor’s net returns from an investor are calculated after taking into account the expense ratio charged by the scheme. The higher the expense ratio, the lower will be the investor’s net returns.

Conclusion

When interest rates were doing southwards, debt fund investors made substantial returns. Now, as we battle with inflation and the central bank struggles to revive the economy, the policy repo rate is being adjusted upwards. Experts believe that, in the short term, the RBI may raise rates in a staggered manner. Thus, as rates rise, it is wise to switch to short-term funds like overnight funds instead of long-term debt funds. 

FAQs