What Is Notching?
Let me explain notching directly to you: it's the practice where credit rating agencies assign different credit ratings to specific debts or obligations from a single issuer or closely related entities.
These distinctions come from differences in security or priority of claim, leading to varying degrees of potential losses if there's a default. So, while a company might have an overall 'AA' rating, its junior debt could be notched down to 'A'.
Key Takeaways
- Notching means a credit rating agency adjusts the rating up or down for an issuer's specific debts or obligations.
- This differs from upgrading or downgrading the entire company or issuer.
- Riskier debts like subordinated ones get notched lower, while senior secured debts might get notched higher.
- You evaluate debt notches by comparing individual bond ratings.
How Notching Works
Companies receive credit scores from agencies that assess their creditworthiness and ability to pay debts. But when a company issues various debts—like secured versus unsecured—or obligations like preferred shares, the ratings on those can differ from the overall company rating due to unique risks.
Agencies like Moody's and S&P notch instruments within the same corporate family based on their position in the capital structure and collateral level. The starting point is senior unsecured debt (base = 0) or the corporate family rating. Notching also covers structural subordination, such as holding company debt being rated lower than subsidiary debt that owns assets directly.
Remember, notching isn't exact; agencies might use different methods, so the same issuer could get varying ratings from different agencies.
Moody's Updated Notching Guidance
In 2017, Moody's updated its 2007 methodology. Here's what applies in most cases: senior secured debt gets +1 or +2 notches above base, senior unsecured is 0, subordinated debt is -1 or -2, junior subordinated is -1 or -2, and preferred stock is -2.
In rare cases, they notch beyond -2 to +2 if the capital structure is unbalanced, the legal regime is unpredictable, or there's extra corporate complexity.
Tranche Notching
Notching isn't limited to bonds; it evaluates credit risk in structured finance like CDOs, which are backed by asset pools such as mortgages. This is tranche notching, where different slices of the CDO get ratings based on subordination—lower-ranked tranches are riskier and rated lower, senior ones higher.
Example of Notching
Consider ABC Company issuing Bond A (senior) and Bond B (junior). Initially, both get an 'A' rating matching the company's strong profile.
If the company's finances worsen, leading to a downgrade to 'BBB', notching applies: Bond A might become 'BBB+', Bond B 'BBB-', showing a two-notch difference due to priority.
What Is a Notch in Bond Rating?
In bond trading, a notch measures the credit risk difference between two bonds from the same issuer, calculated as the rating difference—like one notch from 'A-' to 'BBB+'.
Why Is Notching Important?
Notching helps you as an investor understand creditworthiness through clear ratings, assessing default likelihood to decide on risk levels, especially for high-yield bonds. Issuers use it to spot areas for financial improvement to attract investment.
What Is a Notch Downgrade?
A notch downgrade decreases a bond's rating, expressed in notches, due to deteriorating creditworthiness from factors like declining performance or more debt. This can raise borrowing costs and signal higher default risk to you as an investor.
What Is Subordination-Based Notching?
This method rates credit risk by debt subordination levels—higher priority debts are senior and likely repaid first in default. Issuers with more subordinated debt get lower ratings, common in evaluating CDOs.
The Bottom Line
Notching rates various bonds from the same issuer using discrete levels based on riskiness, terms, and subordination. It determines default likelihood, credit ratings for payment ability, and the risk premium you should demand as an investor.
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