how notching works
companies are given credit scores by specialist credit rating agencies which evaluate a firm s creditworthiness and its 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 notching is not a precise science and credit rating agencies may use different approaches to determine the credit risk of bond and debt issuers as a result it is not uncommon for different credit rating agencies to assign different credit ratings to the same issuer moody s updated notching guidancein 2017 moody s published an update to its 2007 notching methodology this most recent guidance indicated as applicable in most cases was as follows 12in a small number of cases moody s will notch beyond the 2 to 2 range under one or more of the following circumstances notching is not just used to evaluate the credit risk of bond and debt issuers it is also used to evaluate the credit risk of other types of financial instruments such as structured finance products such as collateralized debt obligations cdos cdos are complex securities that are backed by a pool of assets such as mortgages or corporate bonds the credit risk of a cdo is determined by evaluating the credit risk of the assets that make up the pool this process is known as tranche notching and it involves assigning different credit ratings to different tranches or slices of the cdo based on the level of subordination of the tranches tranches that are more highly subordinated i e ranked lower in the repayment hierarchy are considered to be more risky and are assigned lower credit ratings tranches that are more senior i e ranked higher in the repayment hierarchy are considered to be less risky and are assigned higher credit ratings example of notchingimagine that abc company has issued two corporate bonds bond a and bond b bond a is a senior bond which means that it has a higher priority for repayment in the event of default compared to bond b bond b is a junior bond which means that it has a lower priority for repayment abc company s creditworthiness is evaluated by a credit rating agency which determines that the company has a strong financial profile and is likely to be able to make timely interest and principal payments on both bond a and bond b as a result the credit rating agency assigns abc company an a credit rating and assigns both bond a and bond b an a credit rating as well however over time abc company s financial performance begins to deteriorate it takes on more debt and its profits decline which raises concerns about its ability to meet its financial obligations as a result the credit rating agency conducts a review of abc company s creditworthiness and decides to downgrade the company s overall credit rating from a to bbb in this case the credit rating agency would use notching to express the difference in credit risk between bond a and bond b since bond a is a senior bond it is considered to be less risky than bond b and is assigned a bbb credit rating bond b on the other hand is considered to be more risky and is assigned a bbb credit rating the difference in credit risk between bond a and bond b is expressed as two notches with bond a having a higher credit rating and a lower notch than bond b image by sabrina jiang investopedia 2021