Distinguishing Issuers and Issues
Generally, a counterparty credit rating is published for all companies that have issue ratings, in addition to those firms that have no ratable issues, but request an issuer counterparty rating. Where it is germane, both local currency and foreign currency issuer credit ratings are assigned.
Credit ratings are also assigned to specific issues. In fact, the vast majority of credit ratings pertain to specific debt issues. Issue ratings also take into account the recovery prospects associated with the specific debt being rated. Accordingly, junior debt may be rated below the counterparty credit rating, while well-secured debt can be rated above.
Notching: An Overview
Payment on time, as promised, is critical with respect to all debt issues. The potential for recovery in the event of a default-that is, ultimate recovery, albeit delayed-is also important, but timeliness is the primary consideration; thus, issue ratings are still anchored to the counterparty credit rating.
They are notched up or down from the counterparty credit rating in accordance with established guidelines. They take into account the degree of risk/confidence with respect to recovery. The guidelines also reflect, however, a convention for blending the two rating aspects-namely, timeliness and recovery potential.
A key principle is that ratings of twBBB- and above focus more on timeliness, while ratings below twBBB- give additional weight to recovery. For example, regular subordinated debt is usually rated two notches below a counterparty credit rating that is below twBBB-, but one notch below a counterparty credit rating that is twBBB- or above. Conversely, a very well-secured bank loan or first mortgage bond will be rated one notch above a counterparty credit rating in the twBBB or twA rating categories, but the enhancement could be two notches in the case of a 'twBB' or 'twB' corporate credit rating. In the same vein, for an issuer with an issuer credit rating in the 'twAAA' rating category, subordinated debt need not be notched at all, while at the 'twCCC' level, the gaps between debt types may widen.
The rationale for this convention is straightforward: as the default risk increases, the concern over what can be recovered takes on greater relevance and, therefore, greater rating significance. Accordingly, the ultimate recovery aspect of ratings is given more weight as one moves down the rating spectrum.
There is also an important distinction between notching up and notching down. Whenever a financial obligation is judged to have materially worse recovery prospects than other debt of that issuer-by virtue of its being unsecured, subordinated, or because of a holding company structure-the issue rating is notched down from the counterparty credit rating. Thus, priority in bankruptcy or liquidation is considered in broad, relative terms; there is no full-blown attempt to quantify the potential severity of loss.
In contrast, issue ratings are not enhanced above the counterparty credit rating unless a comprehensive analysis indicates the likelihood of full recovery, defined as 100% of principal, for that specific issue. The degree of confidence of full recovery that results from this more rigorous analysis is reflected in the extent that the issue is notched up. If the analysis concludes that recovery prospects may be less than 100%, the issue is not deemed deserving of rating enhancement, even though it can be valuable indeed to realize, say, 80% or 90% of one's investment and avoid a greater loss.
Since preferred stock is by definition a junior ranking security, preferred stock ratings do not materially factor in the security's junior position to a company's debt obligations in a reorganization or liquidation. However, the risk of a bank's missing a preferred dividend is distinct from the risk of its missing a debt payment, even when the preferred dividend is relatively small. The role and attitude of regulatory authorities, who view preferred stock as risk capital, pose a real threat that preferred dividends could be stopped even while the financial institution continues to service its debt obligations. Accordingly, bank or bank holding company preferred stock is not rated the same as the entity's counterparty rating, but usually two or three notches below, to reflect the inherently greater payment default risk.