Explain credit ratings, notching and where ratings fall short
The idea
Rating agencies assign an issuer credit rating reflecting the probability of default on senior unsecured obligations, and issue-specific ratings that may differ from it. Notching adjusts an individual issue up or down from the issuer rating to reflect its seniority and any structural subordination — debt at an operating subsidiary ranks ahead of debt at a holding company whose only asset is the subsidiary's equity. Ratings are opinions about relative default risk, not about price or suitability; they lag market spreads, are slow to change, and say nothing about liquidity or about the risk of a spread widening short of default.
A practice question
What does notching adjust for?
- Changes in the benchmark yield curveWhy not: Ratings are not a market measure and do not move with the curve.
- The seniority of a particular issue — correct
- The bond's remaining maturityWhy not: Maturity affects a bond's risk but is not what notching addresses. Notching is about rank within the capital structure.
Its structural position relative to the issuer matters too. The issuer rating describes senior unsecured debt, so a subordinated issue or one at a holding company is notched down to reflect its weaker claim.
A harder one
Why is debt issued by a holding company typically notched below debt at its operating subsidiary?
- Because holding companies are smallerWhy not: Balance sheet size is not the issue. A parent can be very large and still rank behind its subsidiaries' creditors.
- Because subsidiary debt is always securedWhy not: Often it is unsecured, and it still ranks ahead. The advantage is structural rather than contractual.
- Because its claim ranks behind theirs — correct
The holding company's claim on the subsidiary's assets ranks behind the subsidiary's own creditors. The parent owns equity in the subsidiary, and equity is the residual claim: in a default the subsidiary's lenders are paid before anything reaches the parent.
The hardest tier
A bond is downgraded but its spread barely moves. What does that suggest?
- That the market moved first — correct
- That the downgrade was an errorWhy not: It may be perfectly correct and simply late. The market reaching the same view first is the ordinary case.
- That the bond is illiquidWhy not: An illiquid bond's quoted spread may be stale, but a non-reaction to public news is more readily explained by the news already being in the price.
The deterioration was priced before the agency acted. Spreads and ratings measure related things on different clocks, and a non-reaction tells you which clock was ahead.
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