Overnight Fund all you need to know about Overnight debt funds

Previously, the notion of a bond or debt structure was introduced and we discussed the initial debt mutual fund, namely, the liquid fund. It is important to remember that while it may not be perceived as such by many people, these liquid funds are vulnerable to default and credit rating risk; this fact was clarified with the Taurus MF and Ballarpur case.

Overnight debt funds are an attractive option as they reduce the risks associated with both corporate commercial paper and treasury bills. Liquid funds typically invest in papers maturing up to 91 days, so consider this type of fund if you want to mitigate the risk factor.

An overnight fund invests in securities which are due to mature within 24 hours. This is akin to providing a loan for one day only; at the beginning of such a day, the Fund manager lends money to a borrower and collects it back soon after.

An ‘overnight debt fund’ is precisely what takes place.

Given that the overnight fund invests (or lends) to 1-day debt obligation, the chance of a shift in credit rating risk is limited. Although a default risk still persists, it is minimal.

The next thing to wonder is – who does the overnight loan go to? The answer lies with an instrument regulated by the Reserve Bank of India called ‘Tri party Repo’ or TREPS.

We don’t need to delve into the specifics of a TREP and why it exists for this topic; all you have to know is that it’s a safe method of lending and borrowing during an allocated period of 24 hours. If you’re interested in learning more, please visit the link provided: https://www.ccilindia.com/FAQ/Pages/TREPS.aspx#1

Take a look at the portfolio of the HDFC Overnight Fund.

One can observe that the entire portfolio of the UTI Overnight Fund consists entirely of TREP.

The entire fund is allocated to TREP only.

We can come to an important conclusion here: every overnight fund invests in TREP instrument, meaning there is no difference in performance between Fund A and Fund B. The only variance would be the expense ratio.

In this module, we have yet to discuss the expense ratio – but we will do so in the upcoming chapter.

Investing in an overnight fund is a great choice for those who wish to set aside money for a relatively brief period. This could be anything from a few days to slightly more than three months – for longer periods, however, it would be better to consider a liquid fund.

It is a waste of time to consider the ‘return’ component of an overnight fund. It is not sensible because the purpose of investing in an overnight fund is primarily for its convenience rather than its return.

If you’re curious, the current overnight funds can yield up to 4-5% a year. Doing the math will give you the exact return.

– Ultra-short duration Fund

The ultra short term debt mutual fund is next in line. Engaging from this point on, this mutual fund offers an interesting experience.

Envision yourself as a debt mutual fund manager. Your responsibility is to identify investment opportunities in the debt arena. Investing the scheme’s corpus in new bond/CP issues is an option, or you could acquire them from the secondary bond market.

Consider purchasing a stock at the initial public offering (IPO) or investing in it from the stock exchanges afterward. When acquiring from the secondary market, the cost of the bond could vary from its primary issue rate.

Why does the price fluctuate? This is due to several factors, such as the demand and supply of the bond.

When a bond is bought, the manager anticipates receiving regular coupon payments during the period it lasts, and once the bond matures, to receive the repayment of the principal.

Let us keep this idea in mind for the moment. We will return to this topic shortly.

Consider another scenario. Your best friend requests you for a loan of Rs.10,000/- and promises to reimburse it within twelve months. You decide to lend the money without any interest.

It doesn’t take long to get your money back – the period stands at a year, with no additional cash flow in matters of interest repayment making it easy to assess.

What would the turnaround time be if a quarterly coupon payment was available as an extra source of income?

It can be hard to give an exact figure, however it’s likely to take you less than a year to recoup your outlay; due to the inflow of cash. If you want to be precise, there are ways of calculating a precise recovery time, but for now let’s leave it at that.

The key thing to remember is that cash flow accelerates the repayment of the principal.

Let’s go back to the discussion we were having before.

Fund manager A invests in a bond, with the following details –

The face value of the note is Rs.1000.

Coupon = 8%

Coupon = 8%

Coupon = 8%

Question – How long will the fund manager A take to recover the money invested in this bond?

One’s intuition suggests that the time frame may be slightly less than three years.

Fund manager B purchases the same bond from the secondary market. Of course, its prices may vary, let’s say they paid Rs.1020 for it.

Question – How long will the fund manager take to recover the money invested in this bond?

A hunch suggests Fund manager B might require a bit more time than manager A to get back the cost of the bond.

Fund manager C purchases the same bond from the secondary market, paying Rs.980 for it.

Question – How long will the fund manager take to recover the money invested in this bond?

Answer – Intuition says Fund manager C will take lesser time to recover the price paid for the bond when compared to Fund manager A.

Here’s the crux:

– Bond prices fluctuate up and down on a daily basis, depending on market conditions.

– The cost determines how long it will take to recoup the investment.

Knowing the precise time needed to recover an investment is essential in bond mathematics. Macaulay’s Duration of a Bond is the metric used to quantify this amount.

It’s essential to understand ‘Macaulay Duration’ when discussing ultra short duration funds:

In accordance with this definition, an Ultra Short duration fund can allocate money to short-term investments such as bills and CPs, which usually have a period of 3 to 6 months (90 to 180 days).

It’s essential to be aware that SEBI later specified this restriction as a portfolio level, rather than each bill or CP. This permits the fund to invest in CPs of less than 90 days and even more than 180 days duration, or even TREPS. However, the Macaulay duration of the entire portfolio must remain between 3 to 6 months.

It’s worth checking out DSP’s Ultra-short duration fund portfolio to get a sense of the situation.

The majority of investments in the ultra-short duration fund are money market instruments, with maturities from 1 day up to 365 days. Predominantly these include corporate commercial papers from various companies, as follows in the portfolio snapshot.

They also invest in debt securities such as Non-Convertible Debentures (NCDs) and Bonds, which have a maturity of at least one year.

The fund manager’s task is to ensure the portfolio’s Macaulay duration follows SEBI guidelines in addition to optimising returns.

Another interesting point to consider here is that the ratings of CPs may differ for money market instruments, however all Bonds and NCDs have the highest triple-AAA rating. This means there is a lower probability of default.

As the bond matures, managers become increasingly concerned with potential defaults, so they usually opt for bonds with AAA ratings.

We must recognise, however, that ultra-short duration funds are not without risk. There is the potential for credit default and rating downgrade.

Who should consider investing in an ultra-short duration fund?

Anyone looking to park money for 1-2 years may find this fund a suitable option, as it allows them to take on some risk with their capital. If they’re alright with the possibility of their money depreciating by a few percentage points, then investing in this ultra short-term fund would be the way to go.

If you won’t need access to your funds for less than a year, then a liquid fund is the best option.

I believe it is only sensible to anticipate a yield similar to the bank’s fixed deposit rate.

– Franklin and Vodafone saga

It is appropriate to consider the drama between Franklin and Vodafone that occurred earlier in the year while we are discussing Ultra-short duration bonds.

Franklin India invested in the debt papers of Vodafone India Limited (VIL), across six different debt schemes, such as Ultra short-duration bond fund.

In October 2019, India’s Supreme Court passed a ruling in favour of the Department of Telecommunications (DoT). This determined that telecom operators must pay for their licence and spectrum usage based on their Adjusted Gross Revenue (AGR).

If you haven’t encountered this issue before, I highly recommend reading Finshots’ informative article on the AGR episode. They did an admirable job of explaining the situation – https://finshots.in/archive/the-final-verdict-on-agr-2/

In summary, after the judicial ruling, VIL was obligated to pay a sum of Rs. 27,000 Crores to DoT as unpaid dues.

This would result in VIL becoming cash-strapped, and consequently, likelihood of them not fulfilling their debt obligations.

Franklin India, acting wisely as a money manager, anticipated all potential implications of the ruling and decided to take a proactive step. They self-imposed a downgrade of VIL’s papers to junk status and wrote off their investment.

Taking into account Franklin India’s Ultra-short bond fund, 4.2% of its portfolio was put into VIL’s paper. So, what impact did that have when facing a useless allocation?

It’s evident that the NAV of the fund is decreasing. Verify it for yourself.

From my perspective, Franklin may take around a year or longer to return to its former NAV. The point of this discussion about Franklin and Vodafone is to demonstrate that debt funds have associated risk; therefore, only invest in them if you are clear about the risks involved.