Notching

Notching is the practice by credit rating agencies of assigning different credit ratings to specific debts or obligations of the same issuer based on their relative risk and priority in the capital structure.

Key takeaways

• Notching adjusts an issuer’s overall rating up or down for particular instruments (e.g., senior vs. subordinated debt).
• Senior, secured obligations typically receive higher (better) notches; subordinated or unsecured obligations typically receive lower (worse) notches.
• Notching reflects relative loss severity and repayment priority, not a change in the issuer’s overall creditworthiness.
• Different agencies may notch the same issuer’s instruments differently because methodologies vary.

How notching works

Credit rating agencies assign a baseline rating—often the corporate family rating (CFR) or the issuer’s senior unsecured debt rating. Individual instruments are then notched up or down from that base to reflect:
* Security and collateral (secured vs. unsecured)
* Legal priority (senior, subordinated, junior)
* Structural subordination (debt issued by a holding company vs. operating subsidiary)
* Contractual features (convertibility, claims on cash flow)

Because legal frameworks, asset separations and capital structures differ by issuer and jurisdiction, notching is judgment-based rather than a precise formula. Agencies may therefore produce different notches for the same instruments.

Moody’s typical notching framework

Moody’s updated guidance (commonly applied) uses the issuer’s senior unsecured debt as the base (0) and typically notches as follows:
* Senior secured debt: +1 or +2 notches
* Senior unsecured debt: 0 (base)
* Subordinated debt: −1 or −2 notches
* Junior subordinated debt: −1 or −2 notches
* Preferred stock: −2 notches

In some cases Moody’s may notch beyond the −2 to +2 range due to:
* An unusually large or small proportion of a specific obligation in the capital structure
* Complex or unpredictable legal regimes
* Extra complexity in legal or contractual structure

Tranche notching (structured finance)

Notching is also used to rate tranches of structured products (e.g., CDOs, CLOs, securitizations). Tranche notching assigns higher ratings to more senior slices (less subordination, lower loss risk) and lower ratings to junior slices (more subordination, higher loss risk), reflecting their position in the repayment waterfall.

Example

ABC Company has two bonds:
* Bond A — senior bond (higher repayment priority)
* Bond B — junior bond (lower repayment priority)

If ABC’s overall credit rating falls from A to BBB, an agency may apply notching so Bond A becomes BBB+ (one notch above the base) and Bond B becomes BBB− (one notch below), expressing their different recovery prospects if the company defaults.

Definitions

• Notch: the incremental step between credit ratings used to express differences in credit risk between instruments from the same issuer (e.g., A− vs. BBB+ is one notch).
• Notch downgrade: a lowering of a specific instrument’s rating by one or more notches reflecting increased credit risk relative to the baseline.
• Subordination-based notching: adjusting ratings according to the legal priority of claims—more subordinated obligations receive lower notches because they face higher loss risk.

Why notching matters

• Helps investors differentiate risk among multiple instruments issued by the same borrower.
• Informs pricing and required yield spreads for different debt classes.
• Signals how recovery prospects vary across the capital structure, which affects portfolio allocation and risk management.
• Affects issuers’ funding costs and how they structure future debt.

Bottom line

Notching translates an issuer’s overall credit profile into instrument-level ratings that reflect real differences in security, contractual priority and expected recovery. It is a judgement-driven tool used by rating agencies to guide investors and market participants on the relative risk of specific debts and structured product tranches.