The SEBI regularisation of mutual funds has helped streamline many of the plethora of funds and cut confusion across the segmentation. It also introduced some new categories which were earlier blurred or were not put together as a segment.
Overnight funds offer better returns than savings bank accounts
In total, the regulator came up with 16 fund categories in debt funds with an interesting and useful category named as overnight funds. I’ve extensively discussed the liquid fund category in this space which as the name suggests are highly liquid and could be used for investing for a short span of time.
Let me explain a bit more clearly. A liquid fund is used for parking in short term funds generally restrict their investments to avenues that have a maximum maturity period of 91 days. In the case of overnight funds, the investments are restricted to overnight securities like CBLO and other call market instruments.
The single most risk with cash is the inflationary risk which makes the money to lose value over time (even if it’s for a single day). We seek investing cash to make better out of it at least, a bit more out of it whilst ensuring the capital remains secured. But, while investing in debt instruments, the two risks that an investor has to counter is default risk and interest risk.
In default risk, the bond issuer may go bankrupt and may not honour the commitment provided in the bond while a change in interest rates could impact the return on the investor’s corpus, leading to an interest risk. Overnight instruments just play within this spectrum in avoiding the interest risk while minimising default risk.
Collateralised Borrowing and Lending Obligation (CBLO) are the collateral from bond issuers to counter the risks of repayment. This is sought out by Clearing Corporation of India (CCIL) which guarantees the issuers payment in that segment.
These are mostly short-term government securities or bonds which the bond issuer has to be pledged with CCIL. As the value of the collateral fluctuates on a daily basis, to cover the losses, CCIL demands an amount proportional to the fall in the value from the issuer.
More importantly, the CCIL-CBLO segment participants also have a window and an obligation to lend. In these instances, the bonds come with both put and call options, which means the bond issuer could be asked to pay in mid-term (put) by the buyer or the issuer buys-back midterm (exercising a call) from the buyer - all within a day’s time.
So, in an overnight bond of the above sort, the sensitivity towards interest rate is non-existent while default risk is countered through the collateral and as the maturity changes each day i.e. fresh purchases are made with maturity happening by next morning. This doesn’t put the entire fund at risk, but they’re realised for that day and fresh investment is made.
The portfolios of these funds have a large proportion of reverse repos whose maturity is for a day and are typically replaced the next day with bonds that mature overnight or other such repos available. These bonds are issued by large corporations, governments and other financial institutions where they have an obligation to maintain certain regulatory requirements other than business needs.
The returns could be low and so is the risk thus they could act as a replacement for savings bank (SB) accounts. The current returns are about 5 per cent – 6 per cent annualised.
However, these funds are exposed to reinvestment risk, where in a scenario of falling interest rates, the reinvestment may lead to lower return going forward, which is a common risk across any accrual fund.
Currently, HDFC, L&T, UTI, SBI are offering it in pure or with a bit of an innovation like derivatives (debt arbitrage) and/or a bit of exposure to uncollateralised corporate overnight bonds, etc. Now, Reliance MF has launched its offering in this space bringing choice to investors.
Investors looking for taking advantage of very short-term needs and who would like to make partial withdrawals at a negligible risk and decent returns could explore these funds. Do remember, these funds were a sub-class of liquid funds prior to the SEBI categorisation. (The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])