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Notching

A practice by different rating agencies to compare credit ratings to specific debts or obligations of an issuing entity

What is Notching?

Notching is a general practice by credit rating agencies to compare ratings of different issuers across a single class of obligations or closely related entities. A comparison of the ratings of different companies is used to reflect the credit-specific risks. Liabilities can be notched lower or higher because of the varying degree of losses, in the event of default.

 

Notching

 

During an evaluation, a company can choose the level of the debt it issues, subject to the existing covenants. The issuer’s overall credit rating may differ from the ratings on such obligations. Priorities only matter if a company is insolvent. However, if a company settles all its liabilities as scheduled, the seniority order is irrelevant.

 

Summary

  • Notching is a practice by different rating issuers across a class of obligations to compare credit ratings for different issuers.
  • Standard & Poor’s Corporation (S&P) and Moody’s Investors Service (Moody’s) are the most popular credit rating agencies.
  • Notching allows liabilities to be notched higher or lower, based on the degree of losses in the event of default.

 

Understanding the Concept of Notching

Two major credit rating companies are Standard & Poor’s Corporation (S&P) and Moody’s Investors Service (Moody’s). The two index providers provide information concerning risk-specific ratings. Also, the credit rating agencies compare ratings of different issuers across a single class obligation.

The quality of debts comes with a dual meaning. First, it shows the likelihood of default, which is determined using financial ratios, including variance in cash flows and interest coverage. Second, it shows the rate of recovery after default. The latter feature is hinged on the number of available assets and the language of the indenture agreement.

The marketability of the issuer’s assets determines the rate of recovery. Also, if a company defaults a single issue, all its debts are immediately rendered due. As such, the chances of default for a company’s issues are equal, except the recovery rates, which may vary depending on issues.

The main techniques used as the base for notching instruments are corporate family rating or the obligator’s unsecured debt. Structural subordination of debts that are issued by subsidiaries is also notched, subject to S&P. For example, the debts of a subsidiary could be rated higher than that of a holding company because the latter directly owns the assets and cash flow of the entire enterprise.

 

Moody’s Updated Notching Guidance

The benchmark expected loss rates define Moody’s ratings. The indexes apply for both fundamental corporate issuers and structured finance transactions. Moody’s idealized expected loss rates exhibit the following characteristics:

  • The percentage difference in risk for rating categories Ba2 and higher, and relative to one higher category is 45% or higher.
  • The percentage difference in risks for rating categories Ba3 and below, and relative to one higher category is below 45%.

 

Moody’s Investors Service applied the above logic to develop simplified guidelines for subordination-based notching, which is used more often. If the senior Unsecured or CFC is Ba2, the following methodology is applicable:

  • Senior Secured Bonds: +1 notch above the base
  • Senior Unsecured Bonds: 0 base
  • Senior Subordinated: -1 notch below the base
  • Subordinated Bonds: -1 notch below the base
  • Junior Subordinated Bonds: -1 notch below the base
  • Preferred Stock: -2 notches below the base

 

If the senior Unsecured or CFC is Ba3, the following methodology is applicable:

  • Senior Secured Bonds: +1 notch above the base
  • Senior Unsecured Bonds: 0 base
  • Senior Subordinated: -2 notches below the base
  • Subordinated Bonds: -2 notches below the base
  • Junior Subordinated Bonds: -2 or -3 notches below the base
  • Preferred Stock: -2 or -4 notches below the base

 

Notching Hybrid Securities

The above guidelines may not fully capture the risks associated with modern hybrid securities. In some cases, issuers may be allowed to omit dividends without necessarily causing broader default. The following questions arise when seeking to justify incremental notching beyond outcomes based on subordination:

  • Whether the risk of payments is deferral material
  • Whether the expected losses resulting from deferral are large enough to warrant notching

 

During comparison on relative potential loss rates, analysts not only focus on the difference in the loss on principal but also on the probability that the hybrid security will plunge into default under unusual circumstances. Even so, companies rarely exercise the option to defer.

A general rule with hybrid securities is that notching is limited to guidance for preferred stock. For example, no further notch would be warranted for a hybrid security that was already notched twice.

 

Applications of Notching

Notching guidelines provide corporate ratings that apply to all industries, except where the terms of increased losses go beyond established standards. Notching is found in banks, reinsurers, and European Non-Financial Corporate Issuers. In banks, Moody’s rating uses the issuer’s senior unsecured rating as a reference point for estimating the indexes in subordinated obligations.

In the case of senior insurers, unsecured debt is rated at the same level as Insurance Financial Strength Rating (IFSR), which is the base on which primary insurers notch their debt ratings. For European Non-Financial Corporate Issuers, the issuance of preferred stock is rare in European countries because of corporate malpractice.

In addition, some issuers do not issue their preferred stock. As a result, guidance for preferred stock always follows Moody’s guidelines for hybrid securities.

 

More Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Bond Issuers
  • Debt Capacity
  • Equity vs Fixed Income
  • Senior and Subordinated Debt