Mutual Funds

Overnight funds steal a march over liquid funds

Radhika Merwin | Updated on July 26, 2020

The gap between returns on these schemes has become almost negligible

Have you been preferring liquid funds over overnight funds to earn that extra return from investing your excess money?

Steep falls in short-term interest rates, changes in valuation rules of money-market and debt securities and tweaks in the risk-management framework may have removed that arbitrage in the near term.

An excess liquidity situation and various policy actions by the RBI, including a sharp cut in repo (to 4 per cent currently) and reverse repo rate (to 3.35 per cent), have led to a steep fall in short-term interest rates over the past few months. Most of the short-term rates are below the repo rate or even below the reverse repo in certain cases.


The fallout?

Returns on liquid funds have fallen sharply to 3-3.25 per cent (annualised) over the past month.

This is a far cry from the 6-7 per cent returns these funds had earned over the past 3-5 years and even lower than the 5-odd per cent return over the past year.

Importantly, the gap between returns on overnight and liquid funds has become almost negligible with overnight funds also delivering about 3 per cent return. This is because the yield curve on debt instruments across one-, two- and three-month tenures is currently flat, implying that returns across these papers are similar.

While the overnight rate is below the reverse repo rate at about 3.1 per cent currently, the yield on one-, two- and three-month commercial papers (CPs) (of NBFCs) are at 3.2-3.4 per cent.

Hence, in the past (over three- and five-year periods), while you could enjoy nearly one percentage point higher returns in liquid funds over your overnight funds (about 80 bps in the past year when returns on both categories moderated significantly), currently there is no incentive to park money in liquid funds if your time horizon is just a few days.

The relatively high risk (credit and duration) in liquid funds, exit load on withdrawal before seven days and recent regulatory changes make it unattractive for you to park money in (for very short term) liquid funds in the near term.

What’s changed?

While liquid funds invest in debt and money-market securities of up to 91 days, overnight funds invest in overnight securities having a maturity of one day. Investing in relatively high maturity papers generally fetch higher returns for liquid funds. It is for this reason that investors have been parking large sums of their surplus in liquid funds even if they have a very short-term horizon of a few days.

But with short-term rates falling sharply in the past few months, liquid fund returns have declined to just 3-3.25 per cent (annualised) over the past month.

Given the persisting excess liquidity in the market and further rate cuts by the RBI in the offing, returns from liquid funds are expected to remain subdued in the near term.

Recent changes to the norms around valuation of debt securities and risk management could impact returns further.

In September 2019, SEBI had directed that liquid funds should hold at least 20 per cent of their portfolio in liquid assets — cash, government securities, T-Bills, etc. This was to come into effect from April 2020.

But owing to the pandemic-led market volatility, SEBI extended the date of implementation to June 30.

So, since the beginning of this month, liquid funds have to set aside 20 per cent of their assets in liquid assets. While many funds already hold some portion in liquid assets, adhering to a specified limit at all times could lower the leeway of the fund manager to earn better returns (as liquid assets generate muted returns compared with, say ,CPs or certificates of deposits (CDs)).

Changes in the norms around valuation of debt securities can have a mixed impact on returns.

Prior to the 2019 regulations, non-traded securities that had a residual maturity of up to 60 days did not have to be marked-to-market.

The threshold moved to 30 days last year, impacting returns of many liquid funds as they shifted their maturity to hover around 30 days or less, to follow amortisation-based valuation and curb volatility in returns.

According to SEBI’s directive last year, all debt papers across maturities had to be marked-to-market on April 1, 2020.

But this was postponed, and has come into effect from beginning of July. This will imply two things.

One, with amortisation-based valuation completely dispensed with and all securities being marked-to-market, the volatility in liquid fund returns will increase.

Two, it could also imply higher returns in funds that follow an aggressive strategy of carrying a higher maturity (as there is no benefit of amortisation-based valuation for a particular maturity debt paper).

Why overnight funds?

The flat yield curve across short-term debt instruments will continue in the near term, owing to the surplus liquidity and the RBI rate cuts in the coming months.

Hence, with overnight and liquid funds now offering almost similar returns, investors may be better off parking their money in overnight schemes in the near term.

Mind you, liquid funds also carry a higher duration risk (more so with the recent tweaks in norms of valuation in securities). To ward off undue duration risk, investors can park their money in overnight funds in the near term.

With liquid funds charging exit load on withdrawals within seven days of investing, it makes all the more sense for investors with a few days’ time horizon to go for overnight funds.

Published on July 25, 2020

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor