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Rating downgrades: Should you shift your money from liquid mutual funds to overnight funds?

After the recent credit-related events, overnight funds are emerging as an alternative. But do you really need to shift from liquid to overnight funds?

, ET Bureau|
May 20, 2019, 06.30 AM IST
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While the risk profile of overnight funds is favourable, their returns are lower compared to liquid funds.
Until recently, liquid funds were considered a safe and tax-efficient avenue for stowing away surplus money. However, recent credit-related events have taken some of the sheen off liquid funds. Even as liquid funds try to get their act together, overnight funds are emerging as an alternative and are vying for investors’ attention. But do you really need to shift from liquid to overnight funds?

Fall from grace
The default and subsequent credit rating downgrade of bonds issued by IL&FS was followed by a spate of debt fund downgrades. The hit taken by some liquid funds particularly spoilt the experience of investors, as these funds are considered the least risky among debt funds.

Liquid funds are also not supposed to take unnecessary credit risk. But in their bid to chase higher returns, they invested in high-yield, low-rated instruments, and had to pay a price. When the risky bonds these funds held were downgraded, the funds’ net asset value (NAV) nosedived, wiping out up to an year’s worth of return. The volatility in liquid fund returns has put off many investors.

Also, the regulator has modified the valuation norms for liquid funds. The new, stricter rules now require funds to mark-to-market (value at existing market prices) all their holdings with maturities longer than 30 days. Earlier, only bonds maturing after 60 days were valued at market prices. Bonds with maturity of up to 60 days used to be valued on amortisation basis.

These liquid funds have topped the charts
But investors shouldn’t go by returns alone and look at funds’ asset quality too.
liquid-funds
Source: ACE MF. Data as on 13 May

Overnight funds gave lower returns
Opt for overnight funds only if you want to avoid risk entirely.
overnight-funds
Source: Value Research. Data as on 13 May

Under this system, the difference between the purchase and redemption prices on maturity of the instrument is spread over the tenure of the instrument. The value of all instruments amortised in this manner increases every day, artificially limiting the volatility in the fund’s return. This prevents the fund’s NAV from accurately reflecting the realisable value of its portfolio at any time, leading to nasty surprises when an adverse credit event occurs.

But now, the NAV of liquid funds will accurately reflect the market reality. The new rules are also expected to bring down the returns from liquid funds as fund managers are likely to start favouring bonds with up to 30-day maturity. Shorter the maturity of bonds, lower is the likely gain from any fall in interest rates.

But don’t exit liquid funds
The launch of overnight debt funds has coincided with liquid funds’ fall from grace. Overnight funds are positioned higher on the safety ladder relative to liquid funds. As the name suggests, these invest purely in bonds with maturity of only up to one day.

The funds reinvest their corpus in fresh one-day maturity instruments every day. These are the safest debt instruments, bearing little to negligible interest rate risk and are also immune to credit risk as they are backed by collateral. Several fund houses have come out with overnight funds and some others have them in the offing.

So, if you have already invested in a liquid fund, should you replace it with an overnight fund? While the risk profile of overnight funds is favourable, their returns are comparatively modest. A majority of the liquid funds have comfortably delivered 7.4%-7.6% return over the past one year, while overnight funds have clocked around 6.2%-6.3%.

Dhawal Dalal, Head, Fixed Income, Edelweiss Mutual Fund, argues, “The differential in returns between the two is substantial, even though the gap in their risk profiles is much less evident.” Most liquid funds continue to exhibit quite low risk as their portfolios are heavily tilted in favour of AAA or equivalent rated securities.

Investors need not abandon liquid funds in favour of overnight funds, say experts. Liquid funds whose portfolio holdings enjoy the highest credit ratings are quite safe. “After six months of visible pain in the corporate bond market, investors now have a fair idea where the problems lie and which funds maintain a quality portfolio,” says Mahendra Jajoo, Head, Fixed Income, Mirae Asset Mutual Fund. Besides, most liquid funds have now cleaned up their portfolios.

Also, even if their returns slip as some fund managers shift to bonds with less than 30-day maturity, their return profiles will remain superior to those of overnight funds. Jajoo argues that overnight funds are seasonal picks at best. “Overnight funds are fashionable when trouble erupts in the bond market or when the fear index is elevated,” he says.

Besides, now that liquid fund NAVs are expected to better reflect market realities, investors need not lose sleep over hidden risks in the portfolio. Liquid funds should remain the instrument of choice when parking idle money for the short term. “Only if investors wish to avoid even the slightest chance of risk, then shifting to overnight funds may be justified,” says Dalal.
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