​

What is an Overnight Mutual Fund?

 

Overnight funds are debt funds that lend to corporates for 1 business day. The corporates eligible for borrowing through this route are regulated and are mostly banks, insurance companies, mutual funds, provident funds, and NBFCs

 

Advantages of Overnight Funds

​

• Safest debt funds which can be used for parking money for a few days

• No risk of default as borrowers need to give prescribed securities as collateral

• Zero-risk means you have to settle for low returns

​

How do Overnight Mutual Funds Work?

​

​

Overnight funds, as the name suggests, invest in financial instruments with very short maturities, typically one day. Here are some key points 

​

Investment Instruments:

​

1. CBLOs (Collateralized Borrowing and Lending Obligations):

   • These are short-term money market instruments where securities are used as collateral for borrowing or lending money.

2. Overnight Reverse Repos:

   • These involve selling securities with an agreement to repurchase them the next day at a slightly higher price, effectively serving as a short-term loan.

3. Money Market Securities:

   • Overnight funds may also invest in other debt or money market instruments with very short maturities.

​

SEBI Norms:

• SEBI (Securities and Exchange Board of India) regulations mandate that overnight funds invest only in assets with overnight maturity. This restriction is in place to ensure the funds maintain a high level of liquidity and can meet redemption requirements.

​

Portfolio Dynamics:

• The entire asset holding of an overnight fund is classified as "Cash and Cash Equivalents," emphasizing the short-term and highly liquid nature of the investments.

• The portfolio of overnight funds is replaced daily, reflecting the strategy of holding securities with very short maturities.

​

Sources of Earnings:

• Interest Payments:

  • Overnight funds primarily earn through interest payments on their debt holdings. Since the securities mature in one day, the interest earned is a key component of the fund's returns.

• No Capital Gains:

  • Due to the extremely short maturity of the securities, there is little to no scope for earning capital gains. The focus is on generating income through interest rather than price appreciation.

​

Sensitivity to Market Conditions:

• Interest Rate Sensitivity:

  • Returns of overnight funds are closely tied to prevailing overnight lending and borrowing rates. When interest rates decline and short-term liquidity is ample, overnight rates in the money market tend to decrease, impacting the returns of these funds. Conversely, rising interest rates and tight market liquidity can lead to higher overnight rates and potentially increased returns for the funds.

​

Risk Management:

• Restrictions on Risky Instruments:

  • Overnight funds are restricted from investing in deposits or specified risky debt instruments. This limitation is in place to mitigate the risk of default in their bond portfolio and aligns with the low-risk profile typically associated with such funds.

​

Who Should Invest in Overnight Funds?

​

Investors with a very short investment horizon:

​

Overnight funds are ideal for those with an investment horizon of one week or less, as investors can redeem after holding the units for even one day. This flexibility is a big advantage of overnight funds over liquid funds, which now charge an exit load for redemptions within seven days.

​

Medium to Route Investments in Equity Funds:

​

​Investors who do not want to take any risks until they move to equity can hold funds in an overnight fund. From these funds, investors can use an STP to route investments systematically into an equity fund. This allows them to invest in equity over time while ensuring that the corpus is held safely in the overnight fund.

​

Taxation on Overnight Funds

 

Investors earn dividend income and capital gains from overnight funds. Dividend income is not taxed in the hands of investors. Capital gain is the difference between the purchase price and the selling price of the units. The rate of tax on capital gains depends on the time for which the investor holds the units of the overnight fund.

​

Short-term Capital Gains Tax:

​

• If an investor stays invested for up to 3 years, capital gains are considered short-term capital gains and taxed at the income tax slab rate applicable to the investor.

​

Long-term Capital Gains Tax:

​

• If an investor sells the units of an overnight fund after holding it for longer than 3 years, it is considered as long-term capital gain, and the investor gets the benefit of indexation. This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. In other words, the taxable amount is reduced due to indexation. Long-term capital gains are currently taxed at a lower rate of 20%.

​

In summary, overnight funds serve as a vehicle for investors seeking low-risk, highly liquid investments with a focus on generating income through short-term interest payments. Their returns are closely linked to prevailing interest rates and conditions in the overnight market for funds.