What is Notching?
Notching is a practice used by credit rating agencies to assign different credit ratings to specific obligations or debts of a single issuing entity or closely related entities. This distinction is based on differences in security or priority of claim, meaning some debts might be deemed riskier and thus be rated differently. For instance, a company might have an overall credit rating of ‘AA,’ but its junior debt could be rated ‘A’.
Key Insights
- Diverse Rating Allocation: Notching involves credit rating agencies adjusting ratings up or down for specific debts or obligations.
- Individual Assessment: This method differs from upgrading or downgrading an issuer’s overall credit rating.
- Risk Evaluation: Subordinated debts, inherently riskier than senior debts, are often rated lower.
- Secured Obligations: Debts secured by collateral may receive a higher rating.
- Comparative Analysis: Evaluating credit risks between various bonds provides clarity.
How Notching Operates
Credit rating agencies assess a company’s creditworthiness, estimating its ability to honor debt payments and other obligations. Companies may issue several types of debts, such as secured vs. unsecured, which have unique risks. Consequently, these individual debts or obligations might possess different ratings from the company’s overall credit rating.
Major rating agencies like Moody’s and Standard & Poor’s often notch instruments up or down depending on their placement in an issuer’s capital structure and collateral levels. For instance, a holding company’s debt might be rated lower than its subsidiaries’ debt due to the latter having more direct access to assets and cash flows. Although notching isn’t a precise science, and methodologies can vary among different credit agencies, it remains a significant practice for distinguishing credit risk among an issuer’s multiple debts.
Moody’s Updated Notching Guidance
In 2017, Moody’s updated its notching methodology. The guidance, applicable generally, includes:
- 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
Exceptions to this range (-2 to +2) apply when:
- Capital structure imbalances occur.
- Legal regimes are unpredictable.
- Corporate legal structure complicates risk assessment.
Tranche Notching
Notching also extends to assessing the credit risk of structured financial products, like collateralized debt obligations (CDOs). ‘Tranche notching’ assigns different credit ratings to CDO tranches based on their subordination level, indicating varied repayment hierarchies. Senior tranches will typically receive higher ratings due to lower perceived risk compared to more subordinated tranches.
Example of Notching
Imagine ABC Company issuing two bonds, A and B. Bond A, a senior bond, has priority in default scenarios over Bond B, a junior bond. If ABC’s financial situation degrades and its overall rating drops from ‘A’ to ‘BBB,’ notching helps express the increased risk disparity. Bond A might receive a ‘BBB+’ rating, whereas bond B could be rated ‘BBB-,’ reflecting a two-notch difference.
Notional Illustration
Importance of Notching
Notching enables investors to gauge the risk associated with different bonds issued by the same entity, aiding informed investment decisions, particularly crucial in high-yield bond markets. Meanwhile, issuers gain insight into areas needing financial health improvements to attract investors.
Notch Downgrade
A notch downgrade occurs when a bond’s credit rating decreases. For instance, a downgrade from ‘A-’ to ‘BBB+’ represents a one-notch risk increase. Such downgrades can result from various issues, including declining financial performance or adverse market conditions, affecting the issuer’s ability to meet obligations.
Subordination-Based Notching
This method assesses credit risk based on an issuer’s debt subordination levels. Highly subordinated debts, being lower in repayment hierarchy, generally receive lower ratings compared to more senior debts, indicating higher default risk. This approach is prevalent in evaluating structured finance instruments like CDOs.
Conclusion
Notching provides a systematic approach to rating the credit risk of different debts from the same issuer, considering terms, features, subordination, and relative risk. While instrumental in guiding investment decisions through discrete rating levels, notching also helps debt issuers identify areas for financial improvement, ultimately enabling more strategic financial planning.
Related Terms: Credit Rating, Senior Debt, Junior Debt, Tranche Notching, Subordination-Based Notching, Moody’s, Standard & Poor’s.
References
- Moody’s Investors Service. “Moody’s Updates Its Cross-Sector Methodology for Notching Instrument Ratings Due to Differences in Security and Priority of Claim”.
- Moody’s Investors Service. “Notching Corporate Instrument Ratings Based on Differences in Security and Priority of Claim”, Page 4. (Login Required.)
