In this article we cover

  • 1) What is a Debt Mutual Fund?

    2) Best Debt Funds in 2022 – Liquid Fund Category

    3) Best Debt Funds in 2022 – Short Term Debt Funds Category

    4)Best Debt Funds in 2022 – Long Duration Funds Category

Debt fund investors can finally breathe a sigh of relief. The Reserve Bank of India (RBI) has kept the repo and the reverse repo rate unchanged for the 10th consecutive time. This is positive news for debt funds in India because debt funds and interest rates have an inverse relationship.

So, when interest rates are falling or holding steady, there is an increase in the demand and market value of the underlying bonds. This leads to an increase in the net asset value (NAV) of debt mutual funds. So, for the time being, it looks like debt fund investors have dodged a bullet.

But the question is ‘for how long?’. Because sooner or later, the RBI will start increasing the interest rates to control inflation in the economy. This will make the existing bonds unattractive and their demand and prices will tumble. This will lead to a fall in the NAV of debt mutual funds.

Now unfortunately, you cannot avoid interest rate risk as it is a part and parcel of investing in debt mutual funds. But you can prepare against it by creating an all-weather portfolio of the best debt funds from various categories. And this is precisely what we are going to do in this article.

In today’s article we will take a look at the best debt funds in 2022 across categories like liquid funds, short-term and long-term debt funds. But first let us understand the basics of debt funds. We will be starting with what is a debt fund and how or why they react to interest rates changes.

Best Debt Funds in 2022

What is a Debt Mutual Fund?

Debt refers to a loan. So, debt mutual funds are schemes which pool money from lakhs of investors. This pooled money or assets under management (AUM) is then used to purchase bonds or debentures issued by private, public or government entities. So, when you invest in a debt fund, you are indirectly giving a loan to corporates and the government.

Watch our video on what are debt mutual funds to understand the complex world of debt fund investing

Debt mutual funds invest in the following debt instruments –

  • Corporate bonds
  • Convertible and non-convertible debentures
  • Treasury bills
  • Commercial papers
  • Certificates of deposit
  • Government securities
  • Zero coupon bonds etc.
  • Additional tier 1 and 2 bonds etc.

Like any normal loan, these debt instruments also carry a fixed rate of interest and a fixed maturity date. So, the cash inflow that you will receive from a debt fund is more or less guaranteed. This is not the case with equity mutual funds. There, your inflow is dependent on the company’s performance. Since debt instruments are secured in nature, their payout is stable and consistent.

The table below shows the portfolio of Aditya Birla Sun Life Short Term Debt Fund , one of the best short-term debt funds in 2022.

Company Instrument Credit Rating Credit Rating
6.40% National Bank Agr. Rur. Devp 31/07/2023 Non-Convertible Debenture AAA 4.58
5.63% GOI 2026 GOI Securities SOV 4.57
GOI 22/09/2033 GOI Securities Floating Rate Bond SOV 2.53
7.68% L&T Finance 2023 Debenture AAA 2.14
8.60% Bihar State 2026 State Development Loan SOV 1.85
8.15% GOI 24/11/2026 Central Government Loan SOV 1.68
Panatone Finvest 364-D 30/08/2022 Commercial Paper A1+ 1.67
8.92% Madhya Pradesh State 2022 State Development Loan SOV 1.65
8.90% State Bank of India Additional Tier 2 Bond AAA 1.64
HDFC 28/10/2024 Debenture AAA 1.61

The total AUM of the fund is Rs 9,320 crore as on January 31, 2022. The fund invests 4.58% of this AUM in non-convertible debentures issued by the National Bank for Agricultural and Rural Development (NABARD). So, as an investor in Aditya Birla Sun Life Short Term Debt Fund –

  • You have given a loan of 4.58% of Rs 9,320 crore to NABARD.
  • This loan carries a fixed rate of interest at 6.40%.
  • This loan will mature in July 2023.

So, your interest income is assured till 2023. This fixed nature of return is what attracts conservative investors towards debt mutual funds.

But investing in debt mutual funds is not as easy as it seems. Why do I say this? Well, because it’s the case of one too many when it comes to debt mutual funds. Investors are spoilt for choice, which only leads to investment blunders.

Now, there are nearly 16 different types of debt funds in India. They range from low-risk debt funds like liquid or overnight funds to high-risk debt funds like credit risk and dynamic bond funds. And each category of debt fund reacts differently to interest rate changes. This is why you first need to understand the relationship between interest rates and your debt funds before you invest in any of the recommended best debt funds in 2022.

Interest Rates and Debt Mutual Funds

Let us continue with the above example of non-convertible debentures (NCDs) issued by NABARD. The coupon rate is 6.40% and the maturity date is July 31, 2023. Now let us assume that at the time of issuing this NCD, the interest rate in the market was holding steady at 4%.

These NCDs were in high demand as they were paying a coupon of 6.40% when the interest rate in the market was only 4%. Now, imagine that the interest rate in the market is up from 4% to 6.50%. What do you think will happen to the 6.40% coupon paying NABARD NCDs? Obviously, investors would like to sell these NCDs and move to higher coupon paying bonds. Here’s how things will play out now –

  • There will be lower demand for these NCDs in the secondary market.
  • When demand falls, the price of these bonds will also fall.
  • We know that price and bond yields are inversely related.
  • So, when the price of the bond falls, its yield to maturity (YTM) will increase.
  • But since the price of the bond has fallen, the total market value of the debt funds’ portfolio will fall.
  • This means the NAV of the debt fund will come down.
  • So, there you have it… whenever interest rates rise in an economy, the NAV of debt mutual funds falls.

Now, long-term debt funds are more susceptible to interest rate changes compared to short-term debt funds. This is because the longer the bond’s lock-in-period, the more loss of coupon you will have to bear.

Here are some key points to remember about interest rates and debt mutual funds –

  • Whenever there is an increase in the interest rates in the economy, the NAV of debt funds falls.
  • When interest rates in the economy falls or holds steady, the NAV of debt funds rises.
  • Short-term debt funds are less susceptible to interest rate changes.
  • Long-term debt funds are ideal when interest rates in the market are falling. This is because your fund manager is able to lock-in higher returns for the long-term.
  • Short-term debt funds are ideal in a rising interest rate scenario. This way your opportunity loss is minimum since you can invest in a higher coupon bond once the existing short-term bonds mature.

Now only decoding the interest rates cycles is not enough. You also need to keep a checklist in mind when you are investing in debt mutual funds. Here are some of the most critical things to keep in mind while investing in best debt funds in 2022.

  • Manage your expectations:

    No two debt funds are the same. As mentioned earlier, there are nearly 16 different types of debt mutual funds in India. And all of them have distinct characteristics. You cannot expect a liquid fund and a dynamic bond fund to react the same way to interest rate cycles.

    A liquid fund is more or less immune from the interest rate cycle since its portfolio is held for not more than one year. So, the volatility of returns or risk is minimal. The same cannot be said for a dynamic bond fund, which invests in a mix of short, medium and long-term papers with longer maturities. Now we all know that risk and return go hand in hand when it comes to mutual funds. Hence, investors need to prepare themselves and realize that the returns generated by liquid funds will be starkly different than a dynamic bond or gilt fund. Managing return expectations is a must when you invest in debt mutual funds. The graph below shows the returns generated by different debt fund categories.

    Performance of Debt Funds

    Liquid funds and credit risk funds stand on two completely opposite spectrums with regards to both risk and return. Hence, expecting liquid funds to deliver a return of 8-10% will be irrational. Hence, it is important to manage your expectations, even if you are investing in the best debt funds.

  • Credit Risk is real:

    There is a common misconception among investors that debt funds are a 100% safe. Unfortunately, the Franklin Templeton debt fund fiasco was a lesson that Indian debt fund investors had to learn.

    Let’s go back to the 6.40% NCDs issued by NABARD. Now, there are two types of risk in this transaction –

    • Will NABARD be able to make timely interest payments?
    • Will NABARD be able to return the principal investment on maturity?

    Credit risk is when the borrower fails to make scheduled interest payments or return the principal on maturity. And during economic downturns, this is an all-too-real risk. Hence, investors must invest in only AAA-rated papers. And if these papers are issued by public or government institutions, then you are sorted.

    So, don’t get swayed by the returns offered by a debt mutual fund. Always and we cannot stress this enough, analyse the credit quality of the underlying papers.

  • Taxation:

    Investors often invest in liquid funds to either start a systematic transfer plan or withdrawal plan. But they fail to take into consideration the taxation of debt mutual funds. The holding period for debt funds is 36 months or three years.

    • So, if you sell your debt fund units before 36 months, then you have to pay a short term capital gain tax (STCG). Basically, your gains will be added to your income and you will be taxed as per your income tax slab.
    • If you sell your debt fund units after three years, then you will have to bear 20% long term capital gains tax (LTCG).

    To avoid paying such high taxes, it is advisable to stay invested in debt funds for a minimum of three years. This is especially true for investors in the highest tax bracket.

  • How Sensitive is your debt mutual fund? :

    You can easily access the sensitivity of your debt fund by studying its modified duration. The higher the modified duration, the higher the fund’s sensitivity towards interest rates changes.

    Liquid funds have bare minimum modified duration whereas credit risk funds or gilt funds have very high modified duration

    Debt Funds Modified Duration
    Aditya Birla SL Short Term Debt Fund 1.68 years
    Aditya Birla SL Liquid Fund 0.13 years
    Aditya Birla SL Credit Risk Fund 1.68 years

    So, a fund’s modified duration plays a crucial role while selecting best debt mutual funds. With these pointers done, let us finally take a look at the best debt mutual funds in 2022.

Best Debt Funds in 2022 – Liquid Fund Category

Best Debt Fund in 2022 - Liquid Fund 1-Year 3-Year 5-Year
Aditya Birla Sun Life Liquid Fund 3.32% 4.58% 5.57%
L&T Liquid Fund 3.30% 3.30% 5.52%
HDFC Liquid Fund 3.28% 4.44% 5.42%
Nippon India Liquid Fund 3.29% 4.56% 5.57%
BNP Paribas Liquid Fund 3.36% 4.54% 5.53%

Best Debt Funds in 2022 – Short Term Debt Funds Category

Best Debt Fund in 2022 - Short Term Debt Funds 1-Year 3-Year 5-Year
Nippon India Short Term Fund 5.40% 7.55% 6.85%
Kotak Bond Short Term Fund 4.44% 7.36% 6.82%
Tata Short Term Bond Fund 3.56% 6.89% 5.22%
Aditya Birla Sun Life Short Term Fund 4.82% 7.70% 7.20%
L&T Short Term Bond Fund 4.03% 7.10% 6.79%

Best Debt Funds in 2022 – Long Duration Funds Category

Best Debt Fund in 2022 - Long Duration Debt Funds 1-Year 3-Year 5-Year
Dynamic Bond Aditya Birla Sun Life Dynamic Bond 5.40% 7.55% 6.85%
Long Duration ICICI Prudential Long Term Bond Fund 3.23% 6.61% 6.51%
Banking & PSU Sundaram Banking And PSU Debt Fund 5.40% 7.55% 6.85%
Gilt Funds ICICI Prudential Constant Maturity Gilt Fund 3.30% 9.42% 8.42%
Credit Risk Aditya Birla Sun Life Credit Risk Fund 6.42% 5.98% 6.43%

This completes our list of the best debt funds in 2022. Now to answer the biggest question of them all – Which debt fund is the best in the current interest rate climate?

I would say, short-term debt funds are your best bet in the coming year. Global economies are battling surging inflation. So, sooner or later the RBI will increase interest rates in the economy to control inflation. When this happens, the long-term bonds and other debt instruments will be worst hit.

So, if your investment horizon is more than three year, then short-term debt funds seem to be a much better option in the current interest rate scenario. Open an investment account with RankMF and start investing in the best debt funds in 2022 with just a few clicks.

Types of mutual funds


Where should one invest with an investment period of up to 3 months?
Liquid funds can be the best option for such investors that comes with a maturity of up to 91 days.
Debt funds can be a better option than other traditional investment options?
Debt funds may yield better returns than FDs and other traditional options. They also don’t have any lock-in period unlike FDs and other options.
Debt funds are suited for long term or short term?
Debt funds fit in for all types of investors - long term and short term investors.

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