The basic premise that guided many individuals and corporates to invest in liquid funds has been shaken thanks to the IL&FS episode.

[Read: How IL&FS episode impacted your investments in liquid funds]

Do you remember that many liquid funds posted steep losses after the defaults of the subsidiaries of IL&FS?

Until then, nobody even imagined liquid funds would face a credit risk.

It’s a harsh reality that credit risk has become a systemic problem today; so has the corporate governance.

As they say, ‘once bitten, twice shy’; hence, since the IL&FS episode, institutional investors have become cautious about parking money in liquid funds.  

Overnight funds have gradually started gaining acceptance instead.

In the recent past, some mutual fund houses including DSP Mutual Fund, IDFC Mutual Fund, Reliance Mutual Fund have filed applications with SEBI to launch overnight funds. ICICI Prudential Mutual Fund and Aditya Birla Sun Life Mutual Fund have already launched their overnight funds.

Why overnight funds?

Industry experts are anticipating tighter prudential norms for the liquid funds.

Following the IL&FS fiasco, liquid funds had experienced redemption pressure, which further exacerbated the liquidity problem for the mutual fund industry. Lately, media stories of  SEBI’s plans to tweak the rules applicable to liquid funds have been making the rounds. Various mutual fund houses aggressively rolling out overnight funds suggest that they expect SEBI to tighten up screws around liquid funds.

As reported by the Economic Times dated November 12, 2018, SEBI might introduce a lock-in requirement for liquid fund investment—a negative for the scheme category. Besides, it might also introduce stricter Mark-To-Market (M2M) rules.

In other words, a mutual fund scheme’s portfolio will reflect the market value of securities being held on a particular day more accurately.

Overnight funds won’t have such constraints.

What’s the difference between liquid funds and overnight funds?

As per the SEBI’s circular dated October 06, 2017, overnight funds are open-ended debt schemes investing in overnight securities with a maturity of one day. They are typically money market instruments, viz. Treasury bill (T-Bills) and Collateralised Borrowing and Lending Obligations (CBLOs).

In comparison, liquid funds, by the regulator’s definition, are expected to invest in debt and money market instrument papers with a maturity profile of upto 91 days. The investment basket of liquid funds is quite diverse. So they invest in a variety of instruments such as Certificate of Deposits (CDs) and Commercial Papers (CPs), which also carry higher risk as compared to other overnight instruments.

Hence, the primary difference is investment preferences based on the maturity profile of the type of credit instrument.

The return potential of an overnight fund is typically compared to the prevailing interest rates in the overnight markets. In other words, they might generate returns in line with the repo rates and inter-bank lending rates in the overnight market, under normal conditions.

Thus, the return potential of liquid funds is better than that of overnight funds and may largely vary between 1.0% to 2.5% depending on the liquidity conditions and the credit environment in the market.  

Will overnight funds eventually replace liquid funds?

Doesn’t look like it. Pears can’t replace green apples just because they are green. However, both of them can coexist. It’s unlikely that overnight mutual fund schemes will cannibalize liquid funds.

Nonetheless, the preferences of investors could vary depending on the liquidity conditions, credit risk environment, and other macroeconomic conditions.

Should you invest in overnight funds?

On the risk-return spectrum, overnight funds are placed at the bottom. This means, they are a very low risk-very low return investment proposition. So, if you are extremely conservative and wish to park money for the very short-term, say from day to a week, one can consider an overnight fund as a substitute for holding money in a savings bank account.

But avoiding liquid funds completely isn’t warranted.

At present, the environment in the credit markets is discouraging with new default stories and rating downgrades coming to the fore. But this doesn’t make all liquid funds bad.

Well-managed mutual fund houses, following robust investment processes and systems don’t take their liquid fund offerings lightly.

Hence, if your risk appetite is low and you want to park money for the short-term or planning for short-term goals that are a few months away, or planning for contingency needs, then consider liquid funds. Ensure that you prudently select the scheme/s.

The core objective of liquid funds is to keep your hard-earned money safe. However, in the pursuit of generating higher yield, fund managers have taken credit risk/s by investing in instruments issued by private entities in the past. This may have not been in the interest of investors looking to safeguard their capital. So, consider liquid funds only if you are open to taking credit risk to a certain extent. Otherwise, overnight funds can be an alternative.

The end note

The IL&FS episode has been an eye-opener (hopefully) for credit rating agencies as well as for mutual fund houses. None of them can take the creditworthiness of any promoter group for granted. Sudden downgrades and steep falls in the Net Asset Values (NAVs) of liquid funds are highly serious issues for investors to forget.

Unless, there’s remarkable improvement on these two fronts, overnight funds might continue their gallop and liquid funds might fail to catch up in this race.

The most unfortunate part about the growing popularity of overnight funds is that mutual fund houses may not be compelled to become serious about risk management processes. If investors switch from liquid funds to overnight funds, fund houses will be encouraged to launch New Fund Offers (NFOs) in the overnight category instead of working on improving the processes to invest in liquid funds.

[Read: Will SEBI Shut Down The Close-ended NFO Factory?]

Perhaps, some of them might improve these only when their AUM falls substantially, and investors return to the instruments banks offer to park their money.

PersonalFN will keep you posted on further developments.

Until then Happy Investing!

Add Comments

Comments
sharmasd2002@gmail.com Dec 05, 2018 Pl keep update over night fund Whether Bank FD is safe compare to liquid fund
svijayk@rediffmail.com Mar 10, 2019 Unless overnight funds are able to generate returns more than interest paid on savings bank accounts they may not find retail takers since interest now a days is paid on daily balances in SB accounts which varies from 31/2 % to 6%. Only you may find only institutional investors, who are not eligible to open SB accounts in banks, under this category

 1