What Is Notching?
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 on 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. Therefore while company A may have an overall credit rating of 'AA', its rating on its junior debt may be 'A'.
- Notching is when a credit rating agency bumps up or down the credit rating on an issuers specific debts or obligations.
- Because certain types of debt, for instance subordinated debts, are riskier than senior debts, the rating on junior debts can be notched lower.
- Similarly, those debts from the issuer that are senior and secured by collateral may be notched higher.
How Notching Works
Companies receive credit ratings agencies that evaluate the firm's creditworthiness and 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.
The base from which an instrument is notched in either direction is an obligor's senior unsecured debt (base = 0), or the corporate family rating (CFR). Notching also applies to the structural subordination of debt issued by operating subsidiaries or holding companies, according to S&P. As an example, the debt of a holding company of an enterprise could be rated lower than the debt of the subsidiaries, the entities that directly own the enterprise's assets and cash flows.
Moody's Updated Notching Guidance
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 base
- Senior Unsecured Debt: 0 (base)
- 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 if: 1) an unbalanced capital structure results in a particular obligation comprising a very small or large proportion of total debt; 2) a legal regime is less predictable; or, 3) there is extra complexity in the legal structure of a corporation.