Bond Notching: Understanding Credit Ratings, Applications, and Implications

Notching is the practice by credit rating agencies to give different credit ratings to the particular obligations or debts of a single issuing entity or closely related entities. Rating distinctions among obligations are made based on differences in their security or priority of claim. With varying degrees of losses in the event of default, obligations are subject to being notched higher or lower. Thus, while company A may have an overall credit rating of “AA,” its rating on its junior debt may be “A.

Companies are given credit scores by specialist credit rating agencies, which evaluate a firm’s creditworthiness and its ability to meet its debt payments and other obligations. However, a company may also issue several types of debts (e.g., secured vs. unsecured) or related types of obligations (such as preferred shares or convertible bonds). As a result, the credit rating on those particular debts or obligations may differ somewhat from the issuing company’s overall credit rating due to unique risks or restrictions on those obligations.

Moody’s Investors Service (“Moody’s) and Standard & Poor’s Financial Services (“S&P”) are two major credit rating agencies that notch up or notch down instruments within the same corporate family depending on placement in an obligor’s capital structure and their level of collateral.

In 2017, Moody’s published an update to its 2007 notching methodology. This most recent guidance indicated as “applicable in most cases” was as follows:

Senior secured debt: +1 or +2 notches above the base (0)
Senior unsecured debt: 0
Subordinated debt: -1 or -2
Junior subordinated debt: -1 or -2
Preferred stock: -2

In a small number of cases, Moody’s will notch beyond the -2 to +2 range under one or more of the following circumstances:

An unbalanced capital structure results in a particular obligation comprising a very small or large proportion of total debt.
A legal regime is less predictable.
There is extra complexity in the legal structure of a corporation.

Notching is not just used to evaluate the credit risk of bond and debt issuers. It is also used to evaluate the credit risk of other types of financial instruments, such as structured finance products, such as collateralized debt obligations (CDOs). CDOs are complex securities that are backed by a pool of assets, such as mortgages or corporate bonds. The credit risk of a CDO is determined by evaluating the credit risk of the assets that make up the pool. This process is known as “tranche notching,” and it involves assigning different credit ratings to different tranches (or slices) of the CDO based on the level of subordination of the tranches.

A notch downgrade is a decrease in the credit rating of a particular bond from a debt issuer. It is expressed in terms of notches, with each notch representing a difference in credit risk. A notch downgrade can occur when the creditworthiness of the bond or debt issuer deteriorates.

Subordination-based notching is a method of rating the credit risk of bond or debt issuers based on the level of subordination of the issuer’s debts. Subordination refers to the ranking of debts in terms of priority for repayment in the event that the issuer becomes bankrupt or is unable to meet its financial obligations.