Dr Dhiraj explains corporate bond ratings and risk premiums for everyday investors on DifferentTruths.com.

In the previous two columns, we began our journey into the world of corporate bonds. We learnt that a corporate bond is essentially a loan given by investors to a company. We also understood that while the interest promised by a bond remains fixed, its market price keeps changing, and that is what ultimately affects the return—or yield—that an investor earns.

At this stage, many readers may be thinking, “This sounds interesting. If I can earn a higher return through corporate bonds than through some traditional fixed-income investments, why shouldn’t I choose the bond offering the highest interest rate?” It is a perfectly natural question. In fact, almost every first-time bond investor asks the same thing. Imagine that you are looking at an online bond platform. One bond is offering a yield of around 7.2 per cent, another is offering 8.1 per cent, while a third is promising close to 10 per cent. Without knowing anything else, the temptation is obvious. Why settle for 7 per cent when someone else is willing to pay 10 per cent?

The answer lies in a simple principle that applies not only to bonds but to almost every investment you will ever make. Higher returns usually come with higher risks. The important question, therefore, is not “Which bond pays the highest return?” The more sensible question is “Why is this bond paying a higher return?” That small change in thinking can completely transform the way we invest.

A Lesson Hidden in Everyday Life

One of the easiest ways to understand bond ratings is to forget about the financial market for a few minutes and think about ordinary life. Suppose two friends approach you for a loan of ₹5 lakhs. The first friend has worked as a government school teacher for the last twenty years. His income is regular; he owns a house, has no significant debt and has never defaulted on any financial obligation. You know him well, and over the years he has built a reputation for honesty and financial discipline. The second friend is also sincere and hard-working, but his circumstances are different. He runs a small business that has experienced losses during the last two years. His income varies from month to month; he already has outstanding loans, and business conditions remain uncertain. Both friends ask for the same amount of money, and both promise to repay it after three years.

Would you charge both of them the same rate of interest? Most people instinctively say no. The first friend appears financially stronger, so lending money to him feels relatively safer. The second friend may repay the loan in full, but there is greater uncertainty. Naturally, you would expect a higher return for taking that additional risk. Without realising it, you have just understood one of the basic principles of the bond market.

Companies borrow money in the same way. Some companies have very strong financial positions, stable cash flows and long records of meeting their financial commitments. Others may have higher debt, uncertain earnings or businesses that are more sensitive to economic conditions. Investors naturally expect different returns from different borrowers.

Why Can’t Every Company Borrow at the Same Rate?

If every company could borrow money at the same interest rate, there would be little incentive for businesses to maintain financial discipline. Think about it from the lender’s point of view. If one company has consistently earned profits for decades, maintains manageable debt levels and has never failed to repay its obligations. In contrast, another company struggles with declining profits and increasing debt; would it make sense to lend money to both at the same rate? Probably not, as the financially stronger company is considered less risky and the financially weaker company is considered riskier. To persuade investors to lend money, the second company usually has to offer a higher return. That additional return is known in financial markets as a risk premium.

In simple words, investors receive extra interest because they are accepting greater uncertainty. This explains why chasing the highest return without understanding the reason behind it can sometimes become an expensive mistake.

Who Decides Whether a Company is Safe?

Most individual investors do not have the time or expertise to analyse hundreds of balance sheets, annual reports and cash flow statements before buying a bond. Fortunately, they do not have to. This is where credit rating agencies play an important role. These independent organisations study the financial health of companies that borrow money from investors. They analyse a wide range of information, including profitability, debt levels, repayment history, future business prospects, industry conditions, management quality and the company’s ability to meet its financial commitments.

After conducting their assessment, they assign a credit rating. The purpose of this rating is not to tell investors whether they should or should not invest. Instead, it provides an independent opinion about the company’s ability to repay its debt on time. One may think of a credit rating as a financial health report rather than an investment recommendation.

Which are India’s credit rating agencies?

India has several well-established credit rating agencies whose assessments are widely followed by banks, mutual funds, insurance companies, pension funds and individual investors. Some of the best-known names include CRISIL, ICRA, CARE Ratings, India Ratings and Research and Acuité Ratings & Research. These organisations employ teams of analysts who continuously monitor companies, review financial statements, interact with management, study industry trends and evaluate whether the borrower remains capable of meeting its debt obligations.

It is important to remember that these agencies do not issue the bonds themselves, nor do they insure investors against losses. Their role is to provide an informed professional opinion based on the information available at the time of the assessment.

Understanding Ratings without Memorising them

Many investors become nervous the moment they hear terms such as AAA, AA+, AA or A. They immediately assume that bond investing is becoming too technical. Fortunately, understanding the broad idea is much easier than remembering every rating category.

Think about school report cards. A student scoring ninety-five per cent is generally considered academically stronger than a student scoring seventy-five per cent. This does not mean that the second student is unintelligent or guaranteed to fail in life. It simply reflects the relative assessment of performance at a particular point in time. Credit ratings work in a somewhat similar manner. A company assigned a AAA rating is generally considered to have the strongest capacity to repay its debt. As ratings gradually move lower—to AA, A and beyond—the perceived level of credit risk increases.

This does not mean that every AAA-rated company will always remain financially strong or that every lower-rated company will fail to repay its debt. It simply means that, based on available information, one borrower appears financially stronger than another. That distinction is important because many investors mistakenly treat ratings as guarantees. They are not. They are informed professional opinions based on careful analysis.

Why Ratings May Change Over Time

Just as people and businesses change, credit ratings can also change. A company enjoying excellent financial health today may face difficulties a few years later because of changing market conditions, poor management decisions, unexpected economic events or excessive borrowing.

Similarly, a company facing temporary challenges may improve its financial position over time and receive a higher rating. Credit ratings are therefore reviewed periodically rather than assigned once and forgotten forever. This reminds investors that successful investing requires continuous awareness rather than blind faith.

In the next column, we will understand whether highly rated companies can still default, what Indian investors learnt from cases such as IL&FS and DHFL, whether beginners should invest only in AAA-rated bonds and why experienced investors often say that the highest return is not always the smartest investment.

To be continued

Picture design by Anumita Roy

Dr. Dhiraj Sharma

Dr Dhiraj Sharma, faculty in Management Studies at Punjabi University, Patiala, writes at the intersection of economy, finance, governance, culture, literature, and social change. His interdisciplinary work examines how individuals and institutions adapt to economic and societal shifts. Beyond academia, he pursues creative writing—fiction, non-fiction, poetry—and excels as an avid birder, nature/wildlife photographer, and painter in realistic/semi-impressionist styles. He actively supports government/NGO initiatives for bird watching, butterfly monitoring, and natural habitat conservation. He is our Associate Editor: Economy, Finance and Governance.