CFA CFA Level 2 Notching and Structural Subordination

Notching and Structural Subordination

  • This topic has 5 replies, 3 voices, and was last updated Mar-17 by Zee Tan.
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    • Sarah
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      So the CFAI material doesn’t say much about notching, it doesn’t even have a full paragraph to itself! So a friend and I were trying to walk thought it and were confused notching and structural subordination.

      At a basic level I thought it meant when a companies debt obligations might have different credit ratings.

      Then I tried to expand the definition to something like, notching is part of a bigger concept of cross-default provisions and such. Notching is done for debt based on secondary factors such as priority of payment. I think notching makes more sense if you view it together with structural subordination eg cashflow can’t be sent upstream to a parent company to service the parent’s company’s debt until the subsidiary’s obligations are met. So even if the parent’s company’s debt has seniority the cash generated the the subsidiary level will service its own debt first even if it is a junior issue.

      I was hoping someone could please shed some light on this and if we are on the right wavelength.

    • vincentt
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      Well, I might not be able to explain this accurately but based on my understanding notching means you have different credit ratings for the bond and the said bond’s issuer.

      For example, say Company A issued Bond X, both ‘A’ and ‘X’ and Company A is having a higher rating than X but because the way bond X was structured, makes it riskier hence the rating is lower than the issuer’s (in this case, company A) rating.

    • Zee Tan
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      I’m a bit confused too now (lol) as my understanding is that notching and structural subordination are completely different concepts.

      Structural subordination is the concept that a particular creditor of a parent company will not have claim to the parent’s subsidiaries until all creditors of those subsidiaries have been paid and the parent (as an equity holder) has been paid. I.e., subordination of debt (creditor priority) based on business structure. So what you said in your 3rd paragraph on structural subordination is absolutely right.

      But I’m confused on how does notching blend in. Notching is a rating agency practice, whereby a ratings agency (e.g. Moodys) reduces the ratings of another agency (e.g. Fitch) on structured financial collateral without rating the collateral itself.

      Can you explain further?

    • Sarah
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      @Zee damn I think I was getting something terribly confused.
      So that means this is entirely wrong, “At a basic level I thought it meant when a companies debt obligations might have different credit ratings.”

      In the book notching comes before structural subordination >.< So what is the point of notching? As in why do the rating agency do such things?!

    • Sarah
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      I quote from CFAI books, “Cross-default provisions, whereby events of default such as non- payment of interest on one bond trigger default on all outstanding debt, implies the same default probability for all issues, specific issues may be assigned different credit ratings – higher or lower – due to ratings adjustment methodology known as notching.”

      In the next paragraph it goes on it say…

      “Notching. For the rating agencies, likelihood of default is the primary factor in assigning their ratings. However, there are secondary factors as well. There factors include the priority of payment in the event of a default (e.g., secured versus senior unsecured versus subordinated) as well as potential lose severity in the event of default.”

    • Zee Tan
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      As far as I know, the paragraph about notching is not really about notching, but about how ratings agencies assign their ratings. My take is that some assumptions involving cross-default provisions and structured subordination are taken in the process of notching (which is basically the practice of rating through relative comparison).

      e.g. Consider a bond issued by a parent company and rated Aa by Moody’s. When rating that parent’s subsidiary’s debt, Fitch might decide that the subsidiaries debt ratings must be Aa or higher (since the structurally subordinated debt will only be paid after all subsidiaries debts have been paid off).

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