Liquid Funds Vs Overnight Funds differences are too thin. In such a situation when to use these funds? Are both these categories safe? What are the risks involved?
Liquid Funds and Overnight Funds are considered as best safe parking instruments. However, many are confused about when to use Liquid Funds Vs Overnight Funds. In such a situation, it is first better to understand the basics of these two categories of debt funds in detail.
What do you mean by Overnight Funds?
An overnight mutual fund allocates its investments primarily in bonds with the shortest maturity period, specifically one day. Consequently, its portfolio is predominantly composed of cash and is subject to daily fluctuations. Although the potential for capital loss in this category is minimal compared to other mutual funds, investors must remain aware of additional risks associated with these investments.
The short maturity period of the underlying securities, which is only one day, leads many to consider Overnight Funds as the safest option among all debt funds. Nevertheless, there exists a certain level of risk known as REINVESTMENT RISK that should not be overlooked.
It’s crucial to emphasize that this does not pose any risk to your principal. However, as you might be aware, any changes made by the Reserve Bank of India (RBI) to its reverse repo rate could lessen the attractiveness of investing short-term funds with the RBI. In these situations, investors using overnight funds, which are intended for short-term investments, may experience lower returns, though this does not mean a loss of principal. Therefore, it’s important for you to have a clear understanding of the anticipated returns from Overnight Funds.
Overnight Funds are an advantageous option for temporarily holding excess cash for periods shorter than a week, as they do not impose any exit load. However, it is important to keep in mind that the returns are subject to taxation according to your applicable tax bracket, similar to traditional Bank Fixed Deposits.
The sole benefit of Overnight Funds compared to Bank Fixed Deposits lies in their liquidity, allowing access to funds whenever necessary without incurring any premature penalties, as is the case with Bank Fixed Deposits, or exit loads.
DON’T EXPECT MORE THAN YOUR SAVINGS ACCOUNT INTEREST RATE FROM OVERNIGHT FUNDS!!
What do you mean by Liquid Funds?
Liquid Funds allocate their investments in securities that have a maturity period of up to 91 days. Consequently, these funds are subject to greater risks associated with interest rates, credit, and defaults compared to Overnight Funds, as the latter typically sees the return of capital the following day when the securities held by the Fund Manager reach maturity.
Liquid Funds impose a graded exit load for up to six days (Day 1: 0.0070%, Day 2: 0.0065%, Day 3: 0.0060%, Day 4: 0.0055%, Day 5: 0.0050% and Day 6: 0.0045%) after which there is no exit load starting from the seventh day. These funds are permitted to invest in various money market instruments, such as Certificates of Deposit (CDs) and Commercial Papers (CPs), with maturities of up to 91 days, regardless of their credit quality. Consequently, they may assume a higher credit risk compared to Overnight Funds.
Due to the extended maturity of their portfolios, Liquid Funds have a greater flexibility in managing credit risk, which typically results in higher returns than those offered by Overnight Funds. If immediate access to funds is your primary concern, Overnight Funds would be the more suitable option. Conversely, if you seek to earn returns while holding surplus cash for a period exceeding one week, Liquid Funds would be the appropriate choice.
It is important to keep in mind that liquid funds do not guarantee complete safety, as previously noted. There have been occasions in the past when the net asset value (NAV) of liquid funds has decreased by nearly 7% in a single day. (Refer to my earlier posts “Is Liquid Fund Safe and alternative to Savings Account?” or “Should we invest in Liquid Funds for Long Term Goals?“.).
Otherwise, to understand the risks of debt mutual funds, refer to the series of articles I have written on Debt Funds “Debt Mutual Funds Basics“.
Do remember that certain Liquid Funds offer instant redemption offerings, but it is limited to Rs.50,000 or 90% of the invested amount within 30 minutes to your bank account. Also, all mutual funds will not offer such instant redemption features. As usual, the taxation of Liquid Funds is also like typical Debt Mutual Funds (as per your tax slab. Refer to my latest post on this “Budget 2024 – Mutual Fund Taxation FY 2024-25 / AY 2025-26“.
Liquid Funds Vs Overnight Funds Difference – When to use them?
You now possess a clear understanding of the characteristics of both categories of debt funds. As observed, the taxation for these debt fund categories aligns with that of Bank Fixed Deposits, depending on your tax bracket. Additionally, one should not anticipate returns exceeding the interest rate of a savings account for overnight funds or the short-term fixed deposit rate for liquid funds. Given this context, what purpose do Liquid Funds or Overnight Funds serve, and when should they be utilized?
Overnight Funds are appropriate for situations where funds are required for a duration of less than one week. Conversely, Liquid Funds are more suitable when the need for funds arises within a few months. If you have a clear timeline for when you will need the money, traditional Bank Fixed Deposits (FDs) are advisable. There is no need to complicate your decision between Overnight and Liquid Funds if your requirements are straightforward. However, if you are uncertain about the timing of your financial needs within a short period, either Overnight Funds or Liquid Funds can be utilized. If you possess a sweep-in Bank FD, it is highly recommended to prioritize this option over the aforementioned categories of debt funds.
I hope I have cleared the doubts regarding the Liquid Funds Vs Overnight Funds Difference – When to use them? For simplicity, you can refer to the below image also.
