Overnight Funds: The Relationship Between Liquidity and Performance
Overnight funds are debt mutual funds that invest in securities with a maturity of one business day. Such funds offer high liquidity and the potential to yield better returns than traditional savings accounts.
Overnight funds can be suitable for short-term investments, as an emergency corpus or for portfolio diversification and risk-mitigation. They are also relatively stable investments with low-to-medium risk, which can make them suitable for conservative investors.
- Table of contents
- Features of overnight funds
- Importance of liquidity in overnight funds
- Relation between overnight fund liquidity and performance
- Role of interest rate in overnight funds
Features of overnight funds
Here are the three main features of overnight funds:
- Higher liquidity: One of the key features of overnight funds is their high level of liquidity, because of the very short duration of the underlying securities. Investors can typically redeem their investments on any business day without any exit load or penalty.
- Relatively low interest rate risk: Since overnight funds invest in securities with extremely short maturities, they are relatively less susceptible to interest rate fluctuations compared to longer-duration debt funds.
- Low credit risk: Overnight funds primarily invest in high-quality securities issued by the government, public sector undertakings, and top-rated corporate entities. As a result, they have minimal credit risk associated with defaults on underlying securities.
Importance of liquidity in overnight funds
Liquidity is the ease with which investors can access their funds quickly, without incurring a loss (such as a redemption fee or loss in value). Since overnight funds primarily invest in short-term debt and money market instruments with a maturity of one business day, they are highly liquid.
In case of a financial emergency or if a good investment opportunity arises, investors can easily buy and sell units of an overnight fund to reinvest the money as needed. Such funds can also be used by investors to park idle money with the potential to earn modest returns or for institutions to park surplus cash overnight.
Relation between overnight fund liquidity and performance
To maintain high liquidity, fund managers hold a large portion of the overnight fund’s assets in cash or highly liquid securities with overnight maturity. Because of the short duration and the fact that these are debt instruments, the return potential of such funds is not as high as long-term debt schemes or equity investments.
Role of interest rate in overnight funds
Interest rate risk refers to the potential that a change in prevailing interest rates in the economy will negatively affect the value of investments. Since overnight funds invest in debt securities with very short maturities, they are relatively less sensitive to changes in interest rates compared to longer duration funds. However, these funds are not entirely risk free and investors should be mindful of interest rate changes as they can impact the return potential and NAV of overnight funds. Therefore, it is imperative for investors to assess their risk tolerance and investment horizon before investing in overnight funds.
Conclusion
Liquidity is one of the key features of overnight funds that make them suitable for short-term investors. However, higher liquidity may also have implications on returns, particularly during interest rate changes or heightened market volatility.
FAQs
Are FDs better than overnight funds?
The investment avenue that is the right fit for you depends on your investment goals and horizons. Fixed deposits or FDs offer fixed returns if you stay invested until the maturity date. However, you may incur a penalty if you want to redeem your money early. In contrast, overnight funds can be redeemed as needed without paying any penalty. Also, the returns from overnight fund investments depend on the market movements. However, FD returns are guaranteed, and bank deposits are one of the safest investment avenues.
What is the overnight fund investment liquidity and performance relation?
High liquidity is generally beneficial for investors in terms of accessibility and risk mitigation. However, it may also have implications on returns, particularly in environments of low interest rates or heightened market volatility. Overnight funds have a slightly lower return potential compared to funds with medium-term or long-term debt funds and equity funds and are usually recommended for very short-term investments.
How are overnight funds taxed?
Overnight funds are taxed as debt funds. The capital gains (irrespective of the holding period) from units purchased after April 1, 2023, are added to the investor’s total income and taxed based on the applicable slab and do not have indexation benefit.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.