Credit Rating Agencies (CRAs) evaluate the creditworthiness of companies, assigning them either investment or non-investment grades based on their ability to meet debt payments and other obligations. Companies often issue various types of debt, such as secured or unsecured obligations, leading to differences in the ratings of these debts compared to the company’s overall credit rating.

Notching is distinct from upgrading or downgrading a company or issuer as a whole. It refers to the practice of assigning different credit ratings to specific debts or obligations of an issuing entity or closely related entities. This typically happens due to the structural subordination of debt issued by operating subsidiaries or holding companies. For example, a holding company’s debt might receive a lower rating than the debt of its subsidiaries.

Notching also applies to evaluating the credit risk of other financial instruments, such as structured finance products, including Collateralized Debt Obligations (CDOs). Different Rating agencies may use similar but distinct approaches in determining the ratings of bond or debt issuers, which can lead to different credit ratings for the same issuer from different agencies.

Rating distinctions among obligations are based on differences in their security or priority of claim. With varying degrees of potential losses in the event of default, obligations can be notched higher or lower. In bond trading, a notch measures the difference in credit risk between two bonds issued by the same issuer. Therefore, not every bond issued by a company will necessarily receive the same credit rating.

For example, consider a company that issues two separate debt obligations: Bond A and Bond B. If Bond A is deemed less risky, it might be assigned a BBB+ credit rating, while Bond B, considered riskier, might receive a BBB- rating. This two-notch difference indicates that Bond A has a higher credit rating (and lower credit risk) than Bond B.

A notch downgrade involves a decrease in a particular bond’s rating relative to the debt issuer’s rating. Each notch represents a difference in credit risk. A notch downgrade can occur when the creditworthiness of the bond or debt issuer deteriorates.

Understanding the concept of notching in credit ratings is crucial for both issuers and investors. For issuers, it highlights areas where financial health may need improvement. For investors, it provides essential insights for making informed decisions on debt instruments issued by the same entities.