Key Takeaways
- Adjusts debt ratings relative to issuer's baseline rating.
- Reflects repayment priority and recovery risk differences.
- Senior secured debt rated higher; subordinated rated lower.
- Helps investors price risk across issuer's debt instruments.
What is Notching?
Notching is a credit rating agency practice where agencies adjust the credit ratings of specific debt instruments relative to an issuer’s overall rating to reflect differences in repayment priority and recovery risk. This approach ensures that secured debt, subordinated debt, and structurally subordinated obligations receive distinct ratings based on their position within the capital structure.
The process helps investors understand risk variations within a single issuer’s debt, even when default probability is uniform across instruments, making it essential for evaluating complex credit profiles and obligor risk.
Key Characteristics
Notching accounts for structural and recovery differences across debt instruments. Key features include:
- Rating adjustments: Debt is either notched up or down from the issuer’s baseline rating, such as the corporate family rating or senior unsecured rating.
- Priority in capital structure: Senior secured debt typically receives a higher rating due to collateral backing, while subordinated debt is rated lower reflecting higher risk.
- Structural subordination: Debt issued by subsidiaries may be notched down compared to parent company debt because of cash flow limitations.
- Recovery focus: Notching emphasizes expected recovery values rather than default probability, often linked to concepts like salvage value.
- Dynamic methodology: Agencies update their notching criteria regularly to reflect market and legal changes.
How It Works
Credit rating agencies start with the issuer’s corporate family rating or senior unsecured rating as a baseline. They then apply notches based on factors such as collateral support, subordination level, and expected recovery rates to assign individual debt ratings.
This approach differentiates debt instruments within the same issuer by analyzing their position in bankruptcy hierarchy and structural protections. For example, senior secured bonds backed by assets may be rated several notches higher than unsecured or subordinated bonds. Agencies like S&P and Moody’s use empirical and judgmental models to finalize these adjustments.
Examples and Use Cases
Notching is widely applied across industries to clarify credit risk and inform investment decisions. Common examples include:
- Airlines: Delta may have senior secured debt rated higher than its subordinated bonds, reflecting collateral priority and recovery prospects.
- Banking sector: Moody’s often references senior unsecured ratings when notching subordinated debt issued by banks, influencing how investors assess risk in bank stocks.
- Large-cap companies: Firms featured in large-cap stock indexes may exhibit notching across various debt tranches, clarifying risk profiles for investors.
- Bond investments: Understanding notching assists in selecting suitable fixed-income securities, complementing insights from guides like best bond ETFs.
Important Considerations
Notching provides crucial granularity in credit ratings but requires careful interpretation. You should consider legal frameworks and indenture terms that might affect recovery rates and lead to deviations from standard notching patterns.
Additionally, notching does not change the overall default probability of the issuer but highlights variations in loss severity across debt classes. This distinction is vital for portfolio risk management and pricing, especially when evaluating baby bonds or other subordinated instruments.
Final Words
Notching adjusts debt ratings to reflect differences in repayment priority and recovery risk, providing a more accurate credit profile for each instrument. Review the notched ratings carefully when comparing bonds or debt securities to understand their true risk and potential returns.
Frequently Asked Questions
Notching is a practice where credit rating agencies adjust the ratings of specific debt instruments relative to an issuer’s overall corporate rating. This reflects differences in repayment priority and recovery risk among various types of debt.
Agencies apply notching to account for factors like priority in the capital structure, structural subordination, and recovery rates. This helps differentiate risk levels and recovery prospects among different debt types from the same issuer.
Senior secured debt is usually notched up because it has collateral priority, making it safer, while subordinated debt is notched down due to lower repayment priority and higher risk of loss in default.
Structural subordination occurs when debt issued by a subsidiary is rated lower than the parent’s debt because the subsidiary must meet its own obligations first, limiting cash flows available to parent-level creditors.
Recovery rates, influenced by factors like asset marketability and indenture terms, affect notching by indicating how much investors can expect to recover after default. Different debt classes have varying recovery prospects, leading to rating adjustments.
Yes, notching practices differ by industry and instrument. For example, banks often reference senior unsecured ratings for subordinated debt, and in structured finance like CDOs, tranche notching adjusts ratings based on repayment hierarchy.
Notching helps investors assess the relative risk of different debt issues from the same issuer, influencing yield and pricing. Higher-rated (notched up) debt generally offers lower yields and borrowing costs, while lower-rated (notched down) debt demands higher yields.
