What it means
One company can carry many ratings. The issuer has its base rating, and each instrument earns its own by notching up or down for where it stands in the repayment queue.
Seniority moves the dial: secured debt notches above the base, unsecured sits at it, and subordinated instruments fall notches below, because recovery in default differs by position. Recovery is the real input.
Agencies model what each layer would get back in a failure, and the notch count follows expected loss, not merely the label on the instrument. Academic work formalised the rule: research in Financial Management on the notching rule for subordinated debt examined how ratings reflect the information content of subordination, treating the adjustment as a systematic signal.
Hybrids fall hardest. Instruments with equity-like features, deferrable coupons or deep subordination can lose several notches, which is why a hybrid from a company near the investment-grade boundary can carry a speculative-grade line.
The practice disciplines structure too, since issuers design instruments around notch economics and each notch down raises the coupon the market demands at sale. Methodologies differ by agency.
Each publishes its own notching grid, and the same instrument can sit a notch apart across agencies, a spread that arbitrage-minded treasurers watch. Investors read notches as a map, because the spread between an issuer's layers prices the queue directly and relative-value desks trade one layer against another.
For a business owner issuing layered debt, notching is the price of complexity. Every layer of subordination you create is a coupon premium you pay, visible in the rating letter before the first buyer speaks.
Downgrades cascade through the map. When the issuer rating falls, every instrument falls with it, keeping the notch gaps while the whole structure slides.
For students of structure, the letter tells the story, because reading an agency's notch map for one issuer teaches more about capital structure than any diagram, since every gap is priced recovery.
In practice
Real-world examples.
Example
A company's senior secured bonds are rated A- while its unsecured notes carry BBB at the same agency, a gap of two notches. Security earned the two notches because lenders can look to specific collateral in a default. The letters map the structure, not a change in the company's health.
Example
An industrial group is rated BBB- as an issuer, the lowest investment-grade step. Its hybrid, with deferrable coupons and deep subordination, is rated two notches lower at BB. The group's senior bonds stay investment grade, so the structure carries the discount, not distress.
Example
Two agencies notch the same subordinated issue differently, and the issuer markets the kinder letter in its investor presentation. Buyers who read both methodologies see that the gap reflects different recovery assumptions. A one-notch difference becomes a sales pitch and a due-diligence question.
Formula
Calculation
No universal grid exists, but the pattern recurs: secured at or above the issuer rating, senior unsecured at it, subordinated one to three notches below, deeply subordinated hybrids lower still. Each notch widens the required yield by a spread the market resets daily. Extra annual coupon = notches below senior x spread per notch x principal.
Worked example with invented figures. An issuer is rated BBB, and a subordinated bond is notched three steps below it (BBB-, BB+, BB), landing at BB. If the market charges 0.30% extra per notch, the premium is 3 x 0.30% = 0.90%. On $100,000,000 of bonds that is $100,000,000 x 0.009 = $900,000 a year. If better terms cut the gap to two notches, the premium falls to 0.60%, or $600,000 a year, a saving of $300,000 every year.Case study
Seen in the real world.
In this illustrative fictional case, Ingrid, treasurer of Norwood Industrial Group, prices a hybrid bond for the first time. The group's senior rating is BBB+, and her bank shows the rating path: three notches below senior for subordination and deferral features, landing at BB+, one step below investment grade. She renegotiates the terms, shortening the deferral option and strengthening the claim on assets, which saves a notch and lands the bond at BBB-, inside investment grade.
On $100,000,000 of bonds at an invented 0.30% per notch, the saving is $300,000 a year, more than the one-off advisory fee. Ingrid also finds that the wider investor base available to an investment-grade bond improves demand at pricing. Her board concludes that one notch of structure was worth far more than the effort it took to negotiate.
Watch out
Common mistakes.
- Assuming all of an issuer's debt shares one rating. Each instrument is rated for its own recovery prospects, and the queue position decides the notch count.
- Reading a low hybrid rating as issuer distress. Notching reflects structure, not health, and the same company's senior debt may be rated comfortably higher.
- Ignoring notch economics in design. Each subordination layer raises the coupon, and a saved notch is worth basis points at every payment for years.
Questions
People also ask.
What is notching in credit ratings?
Adjusting an instrument's rating up or down from the issuer's base rating for its position in the repayment queue. Secured debt notches up, subordinated and hybrid instruments notch down.
Why do subordinated instruments rate lower?
Lower expected recovery in default. Research on the notching rule for subordinated debt treats the adjustment as a systematic signal of loss severity, distinct from default probability.
Do agencies notch identically?
No. Each publishes its own methodology and grid, and the same instrument can sit a notch apart between agencies, which is why issuers read every methodology before structuring.
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