Understanding the impact of changing interest rates on overnight funds

In the financial world, understanding the dynamics of interest rates is non-negotiable. Interest rate changes can significantly influence the fate of investments, especially when it comes to fixed income mutual funds. However, certain investment instruments like overnight funds are relatively less susceptible to the movement of interest rates. In this article, we will discuss the impact of changing interest rate on overnight funds.

• Table of contents

1. What are overnight funds?
2. Role of changing interest rate on overnight fund
3. Factors affecting interest rate changes of overnight funds
4. Risk and reward for investing in overnight fund
5. FAQ

What are overnight funds?

Overnight funds are debt mutual funds that invest in fixed-income securities with maturities of one day. These funds are known for their relatively low risk and high liquidity, making them a suitable choice for investors seeking a stable parking space for their money in the short term.

However, while overnight funds are comparatively more immune to interest rate changes that other types of mutual funds, they are not entirely risk-free. Let’s check out the impact of changing interest rate on overnight funds.

Role of changing interest rate on overnight fund

Several factors can change the repo rate and, by extension, change the interest rate on overnight funds. These include:

Monetary policy: The central bank may raise or lower the repo rate to control inflation and economic growth.

Controlling inflation: To combat inflation, the central bank can raise the repo rate. This discourages borrowing and spending, ultimately slowing down economic activity and dampening inflation.

Stimulating growth: Conversely, during an economic slowdown, the central bank can lower the repo rate. This promotes borrowing and spending, aiming to reignite economic growth.

Supply and demand: The supply and demand for short-term funds can also affect the repo rate.

High demand: When the demand for short-term funds from banks and businesses is high, it impacts the rate of newly issues security of 1 day, this affecting overnight fund interest rates.

Abundant supply: Conversely, when there's an abundance of short-term funds available, the repo rate often declines. This leads to lower overnight fund interest rates, reflecting the reduced demand for borrowed funds.

Global economic conditions: International economic conditions can also influence overnight fund interest rates:

Recession: If a global recession looms, central banks around the world might coordinate efforts to stimulate their economies. This can involve lowering repo rates, impacting overnight fund interest rates globally.

Global boom: On the other hand, a period of global economic prosperity might prompt central banks to raise repo rates to prevent excessive inflation.

Risk and reward for investing in overnight fund

Investing in overnight funds comes with its own set of risks and rewards. While these funds are relatively low risk and highly liquid, they are not entirely risk-free.

Risks associated with overnight funds

The main risk associated with overnight funds is interest rate risk. Changes in interest rates can impact the return potential of these funds though to a relatively smaller extent. In a rising interest rate environment, the return potential of existing overnight funds may decrease, whereas in a falling interest rate scenario, the return potential may increase marginally.

However, overnight funds are considered relatively stable compared to other debt funds due to their very short investment horizon and focus on high-quality, short-term instruments. Additionally, there is minimal risk of default since the securities mature the very next day.

Reward potential of overnight funds

Overnight funds can be suitable for parking surplus cash for a very short period as they are associated with a relatively low investment risk. The primary objective of overnight funds aligns with investors who prioritise mitigating impact on capital with the potential for modest returns in the short term.

Therefore, overnight funds are usually considered by large institutions for temporarily parking large amounts of cash. However, small investors and ultra-conservative investors can also use these funds as a relatively stable investment avenue for a short period of time.

Conclusion

By staying informed about the factors influencing interest rate changes and assessing the associated risks and rewards, investors can make well-informed decisions to effectively manage their investments in overnight funds.

FAQs

Are overnight funds a stable investment avenue?

A. Overnight funds are relatively stable compared to other debt funds due to the very short maturity period of the underlying debt securities. However, like all investments, they are not entirely risk-free and are subject a minimal amount of interest rate risk and default risk.

 

What is the interest rate of overnight funds?

A. The interest rate of the instruments held in overnight funds can vary based on the scheme and factors such as central bank monetary policies, economic indicators, inflationary pressures, and market liquidity conditions.

 

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.