Notching

What Is Notching?

Notching is the practice by credit rating agencies to give different credit ratings to the specific obligations or debts of a single giving entity or closely related elements. Rating qualifications among obligations are made based on differences in their security or priority of claim. With fluctuating degrees of losses in the event of default, obligations are subject to being scored higher or lower. In this manner, while company A may have an overall credit rating of "AA," its rating on its junior debt might be "A."

How Notching Works

Companies receive credit ratings agencies that assess the company's creditworthiness and ability to meet its debt payments and different obligations. Notwithstanding, a company may likewise issue several types of debts (e.g., secured versus unsecured) or related types of obligations (like preferred shares or convertible bonds). Accordingly, the credit rating on those specific debts or obligations might vary fairly from the responsible company's overall credit rating due to unique risks or limitations on those obligations.

Moody's Investors Service ("Moody's) and Standard and Poor's Financial Services ("S&P") are two major credit rating agencies that score up or indent down instruments inside a similar corporate family relying upon placement in a obligor's capital structure and their level of collateral.

The base from which an instrument is scored in either bearing is an obligor's senior unsecured debt (base = 0), or the corporate family rating (CFR). Notching additionally applies to the structural subordination of debt issued by operating auxiliaries or holding companies, as indicated by S&P. For instance, the debt of a holding company of an enterprise could be rated lower than the debt of the auxiliaries, the elements that straightforwardly own the enterprise's assets and cash flows.

Moody's Updated Notching Guidance

In 2017, Moody's distributed an update to its 2007 notching methodology. This latest guidance indicated as "material by and large" was as per the following:

• Senior secured debt: +1 or +2 steps over 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 score past the - 2 to +2 territory under at least one of the accompanying conditions:

• An unequal capital structure brings about a specific obligation containing a tiny or large extent of total debt.
• A legal system is less unsurprising.
• There is extra complexity in the legal structure of a corporation.

Features

• Likewise, those debts from the issuer that are senior and secured by collateral might be indented higher.
• Notching is the point at which a credit rating agency knocks up or down the credit rating on an issuer's specific debts or obligations.
• Since certain types of debt — for example, subordinated debts — are less secure than senior debts, the rating on junior debts can be scored lower.