Notching
A notch is a single rung on a credit rating scale (BB+ to BB, for example), and notching refers to the systematic practice by which rating agencies adjust individual debt instruments one or more notches above or below an issuer’s anchor rating based on the legal characteristics of the debt itself. The anchor rating reflects the issuer’s overall creditworthiness; notches account for seniority, covenants, and collateral.
For the adjustment mechanism applied to one’s seniority position, see Through-the-Cycle Rating and Point-in-Time Rating.
Why the same company has different bond ratings
A single corporation may have dozens of bond issues trading in the market, each with its own credit rating. Superficially, this seems odd—why would Acme Corp’s bonds not all have the same rating? The reason is that the rating does not reflect only company health; it reflects the specific obligation’s likelihood of being paid in full and on time.
A senior secured bond backed by the issuer’s equipment has a much higher recovery rate in bankruptcy than an unsecured subordinated bond. A bond with strict maintenance covenants gives the lender early warning of trouble; a bond with minimal covenants does not. A debt instrument maturing in 2 years faces lower interest-rate risk than one maturing in 30 years. Notching captures these structural differences without requiring a separate full-scale rating analysis for each bond.
The anchor rating as starting point
Each issuer receives a single anchor rating (or issuer rating) that reflects overall creditworthiness. This is the rating of the hypothetical, generic, unsecured bond issued by the company. It incorporates leverage, cash flow, industry position, management quality, and macroeconomic sensitivity. Moody’s calls it the Issuer Rating; Fitch calls it the Issuer Default Rating (IDR); S&P uses Corporate Credit Rating.
From that anchor, the agency then notches up or down based on the specifics of each obligation. A senior secured bond might be notched up 2 or 3 notches (if the collateral is strong and covers the debt well). A subordinated bond might be notched down 1 or 2. A short-dated commercial paper might be notched up because maturity is near and refinancing risk is low; a 30-year junior bond might be notched down further because time magnifies risk.
Mapping seniority to notching
The most systematic notching occurs along the seniority waterfall. In bankruptcy:
- Senior secured debt (asset-backed, first lien) recovers most of its principal.
- Senior unsecured debt recovers less (fewer assets available).
- Subordinated debt recovers much less (paid after seniors).
- Preferred equity recovers little if anything.
- Common equity recovers last (usually nothing).
A major rating agency might have a written policy stating: “Senior secured obligations are typically rated 2 notches above the anchor. Senior unsecured obligations receive the anchor rating. Subordinated obligations are typically notched 1 notch below the anchor.” These are guidelines, not immutable rules; a weakly collateralized senior secured bond might be notched only 1 notch up if the pledged assets are illiquid or fluctuate widely in value.
Covenant notching and legal factors
Beyond seniority, covenants and legal restrictions move ratings. A bond with strict negative covenants—restrictions preventing the issuer from taking on additional debt or selling core assets—might be notched up a half-notch compared to a covenant-light bond. Conversely, a bond with a springing financial covenant (triggered only if leverage exceeds a threshold) is weaker than one with a fixed covenant, earning it a downward notch.
Guarantees matter too. If a weak subsidiary’s bond is guaranteed by the parent corporation, it receives a higher rating than the subsidiary’s own unsecured debt. The guarantee raises the recovery probability, warranting a notch or more of uplift. Conversely, a bond of a large holding company, structurally subordinated to its operating subsidiaries’ debt, may be notched down because parent-level assets are furthest away in the payment queue.
Currency and issue-specific notching
Some notching occurs for factors outside company control. A bond denominated in a foreign currency (say, a Japanese yen bond issued by a US company with dollar-denominated cash flows) might be notched down to reflect currency risk. Convertible bonds are often notched higher than straight debt because the equity conversion feature, though sometimes underwater, enhances the bondholder’s upside recovery if the company recovers.
Callable bonds present a special case. A callable bond is notched down slightly relative to a non-callable equivalent because the issuer can refinance away from the holder if rates fall, limiting the holder’s upside—a one-way bet. Conversely, bonds with put rights (allowing the holder to force redemption under stress) are notched up because the holder can exit if conditions worsen.
Notching in practice: worked example
Suppose TechCorp’s anchor rating is BBB (investment grade). Its various bonds might be notched as follows:
| Obligation | Notching | Rating |
|---|---|---|
| Senior secured bank facility (first lien) | +2 | A |
| Senior unsecured public bonds | 0 | BBB |
| Convertible subordinated notes | −1 | BBB− |
| Preferred stock | −2 | BB+ |
Each rating is defensible without re-running the full creditworthiness analysis. Investors can quickly reason: “TechCorp is stable (BBB), so its senior bonds are safe, but the convertible is riskier because it’s subordinated.” Notching operationalizes this intuition.
Notching discipline and criticism
Agencies publish notching matrices so investors can anticipate adjustments. Moody’s, Fitch, and S&P each have guidelines. The transparency helps, but notching is not mechanical—analysts have discretion. A senior secured bond backed by inventory might be notched conservatively if the inventory is obsolescence-prone; the same bond rating at another company, with more stable inventory, might be notched higher.
Critics argue that notching can obscure rising default correlation. If all of TechCorp’s bonds get downgraded in tandem (because the anchor rating falls), notching discipline prevents wide dispersion. Conversely, if agencies are too rigid with notching, they might miss structural deterioration in a specific tranche. The rating for a bond secured by a specific factory should fall if that factory’s productivity collapses, not just when overall company ratings change.
Interaction with covenant design
Companies and their lenders use notching strategies in debt structuring. A borrower aware that senior secured debt is notched +2 has incentive to pledge collateral, because even if the anchor rating is weak, the senior secured portion will still be investment-grade. Similarly, a borrower might push for minimal covenants in the anchor-rated unsecured bond, accepting higher coupon costs, to preserve flexibility. Notching thus shapes the architecture of capital structures.
See also
Closely related
- Credit Rating — the anchor from which notches are applied
- Credit Watch — short-term review that affects all notches in parallel
- Bond — the specific obligation being notched
- Senior Secured Bond — typically notched highest
- Subordinated Debt — typically notched below anchor
- Callable Bond — notched down for issuer optionality
- Convertible Bond — often notched with equity conversion uplift
- Preferred Stock — structural subordination usually brings lower notch
Wider context
- Debt Restructuring — notching reflects terms negotiated in financing
- Bankruptcy Recovery — notching proxies for seniority-based recovery
- Covenant — legal terms that justify notching adjustments
- High-Yield Bond — non-investment-grade issuers with wider notching dispersion
- Leverage Ratio — key input to anchor rating, then translated via notching