Rating Methodology
February 2007
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Jerome Fons
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Updated Summary Guidance for Notching Bonds,
Preferred Stocks and Hybrid Securities of
Corporate Issuers
Notching refers to the general practice of making rating distinctions among the different liabilities of a single entity or
of closely related entities. The conceptual framework underlying Moody's approach to notching was first laid out in a
November 2000 rating methodology report, "Notching for Differences in Priority of Claims and Integration of the
Preferred Stock Rating Scale." In September 2001, Moody's released a special comment "Summary Guidance for
Notching Secured Bonds, Subordinated Bonds, and Preferred Stocks of Corporate Issuers" which outlined its notching practices. This methodology updates the 2001 summary guidance to include hybrid securities and concludes the
November 2006 request for comment "Rating Preferred Stock and Hybrid Securities."
Notching for Subordination
The guidance provided in this section for subordination-based notching applies to all corporate issuers, except those
speculative-grade non-financial corporate issuers subject to Moody's Loss Given Default methodology.1 The guidance integrates a stylized definition of Moody's ratings, expressed in terms of expected-loss rates, with information
about expected relative loss severity in the event of default for the various security classes of a single issuer.
Moody's notching guidelines are intended to ensure that two securities with the same rating have the same
expected loss rate. An obligation's expected loss rate is defined as the product of the probability of default and the
expected severity of loss given default. Generally, it is assumed that the probability of default is linked to the issuer of
the obligation and is consequently the same across all obligations of that issuer. Notching practices based on this
assumption are referred to as subordination-based notching.
Whenever possible, Moody's estimates issuer-specific expectations of relative expected loss severity upon default.
However, relative loss severity estimates alone are insufficient to answer the following key questions:
• Are any differences sufficient to merit a rating distinction?
• If so, should the differences be one notch, two notches, or more?
• And do notching recommendations vary, depending where an issuer's benchmark rating is located on the
rating scale?
As discussed in the September 2001 summary guidance document, in order to answer these questions, one needs
to know the percentage change in expected-loss rates as one traverses the long-term rating scale.
Moody's benchmark expected loss rates define the meaning of Moody's ratings, both for structured finance transactions and for fundamental corporate issuers. In particular, Moody's idealized expected loss (and default) rates exhibit
the following characteristics:
1.
This includes US and Canadian issuers, as well as EMEA issuers from end of March 2007 on. Please see Moody's Rating Methodology "Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate Obligors in the United States and Canada," August 2006 and the November 2006 request for comment "Probability of Default Ratings and Loss Given Default Assessments for Corporate Obligors in Europe, Middle East and Africa:
Recommended Framework."
•
For rating categories Ba2 and higher, the percentage difference in risk, relative to one category higher, is
45% or greater.
• For rating categories Ba3 and below, the percentage difference in risk, relative to one category higher, is less
than 45%.
In order to translate these differences into notching guidance, we need estimates of differences in loss across debt
classes. The table below summarizes the percentage difference in average severity of loss, relative to an issuer's senior
unsecured rating, for a number of debt classes.
Average Loss Severity Rates for Various Debt Classes
(relative to the historical loss severity on the same issuer's senior unsecured bonds)
Secured bonds
Senior unsecured bonds
Senior subordinated bonds
Subordinated bonds
Junior subordinated bonds
Preferred stock
-30%
n/a
40%
52%
62%
85%
For those adjacent rating categories where the percentage difference in risk is greater than 45%, the percentage
difference in loss severity, relative to senior unsecured bonds, must be at least 45% to justify a rating notch. Two
notches would require a difference in loss severity of at least 110%. For rating categories where the percentage difference in risk is less than 45%, a difference in loss severity in excess of 45% would justify possibly multiple rating
notches.
For example, as shown in the table above, subordinated bonds recover on average 52% less than senior unsecured
bonds. Accordingly, they would be notched once if the senior unsecured rating is Ba2 or higher and perhaps twice or
even three times at lower rating levels.
Using this logic, we developed the following, simplified guidelines for subordination-based notching. As mentioned previously, speculate-grade corporate issuers subject to Moody's LGD methodology are not covered by these
guidelines. Also note that no distinction is made between cumulative and non-cumulative preferred stock.
Guidance on Notching for Subordination
If Sr. Unsecured or
Corporate Family Rating
is Ba2 or higher
If Sr. Unsecured or
Corporate Family Rating
is Ba3 or lower
Security Class
Secured Bonds
Sr. Unsecured
Sr. Subordinated
Subordinated
Jr. Subordinated
Preferred stock
Number of Notches
("+" greater than;
"-" less than)
+1
0
-1
-1
-1
-2
Reference Rating
Sr. Unsecured
Sr. Unsecured
Sr. Unsecured
Sr. Unsecured
Sr. Unsecured
Sr. Unsecured
Security Class
Secured Bonds
Sr. Unsecured
Sr. Subordinated
Subordinated
Jr. Subordinated
Preferred stock
Number of Notches
("+" greater than;
"-" less than)
+1
0
-2
-2
-2 or -3*
-3 or -4#
Reference Rating
CFR or Sr. Unsecured
CFR or Sr. Unsecured
CFR or Sr. Unsecured
CFR or Sr. Unsecured
CFR or Sr. Unsecured
CFR or Sr. Unsecured
*Junior subordinated debt is rated 2 notches below senior unsecured (or the corporate family rating), unless a
company has a substantial amount of senior subordinated or ordinary subordinated debt outstanding; then it is rated
3 notches below the senior implied rating.
#Preferred is rated one notch below the lowest rating assigned to any type of subordinated debt.
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Moody’s Rating Methodology
Notching Hybrid Securities
Modern hybrid securities — combining features of debt and equity and usually ranked as either subordinated debt or
preferred stock in terms of priority of claim — pose a unique set of risks that may not be adequately captured in the
guidelines above. In particular, issuers may be allowed — or, in some cases, required — to omit dividends (or other
payments) without triggering a broader default. In order to justify incremental notching beyond subordination-based
outcomes, we must address the following questions:
• Is the risk of payment deferral material?
• If so, are the expected losses due to deferral large enough to warrant a rating notch?
To compare the relative potential loss rates on hybrids and ordinary debt securities, one needs to consider not only
any differences in loss on principal, but also the possibility that the hybrid security will go into "default" under circumstances in which the non-hybrid security does not default, or if it does, it enters default at a later date.2 Given, however, the lack of empirical data on hybrid losses, we are not suggesting incremental notching for deferral risk where
deferral is optional, since anecdotal evidence to date suggests that the option to defer is very rarely exercised. Where
"meaningful" mandatory deferral features are present, however, the following guidance holds:
Hybrid Notching Guidelines
A hybrid security with a meaningful mandatory trigger and a priority of claim
above preferred stock will be rated one notch below the subordination-based (or
LGD derived) rating.
A hybrid security with a preferred stock (or equivalent) priority of claim will have
no additional notching.
As a general rule, notching should not exceed guidance for preferred stock. For example if a hybrid security were
already notched twice because it is deeply subordinated, no further notching would be warranted.
Meaningful mandatory deferral triggers are defined in footnote 8 of Moody's December 2006 Rating Methodology "Supplemental Comments on Rating Preferred Stock and Hybrid Securities":
Meaningful triggers are those set at a level such that they would be breached when: 1) the issuer is
just beginning to experience financial distress (before it is in severe financial distress); and 2) at a time
when the issuer may cut or eliminate its common dividend.
Typically for non-financial corporate issuers, Moody's rating committees have set triggers to be activated when
financial measures correspond to a mid-Ba rating. For financial issuers, the January 2006 Rating Methodology
"Refinements to Moody's Tool Kit: An Addendum for Banks and Insurers," provides further guidance:
Moody's general concept behind meaningful mandatory deferral triggers is, if breached, they result
in the deferral of hybrid distributions and provide cash flow relief in a deteriorating financial situation. The triggers should be based on publicly available financial and/or operating parameters that
best capture an issuer's deteriorating financial condition and not be set at a level that is too tight,
thereby creating the very market access disruption that they were meant to protect against. Moreover, they should not be set at such a low level that they are breached only when the financial institution is in such a severe state of financial distress that it is taken over by regulators. Our view is that
the appropriate level for a trigger breach is close to the time that a financial institution would consider suspending or cutting its common dividend payments.
Moody's ranks instruments with meaningful mandatory deferral triggers and an acceptable settlement mechanism
as "strong" on the "No Ongoing Payments" dimension of its equity credit methodology.3 Such triggers are typically
set at a level that would be crossed before the issuer experiences severe financial stress. The probability of tripping is
considered to be material enough to warrant a rating notch.
2.
3.
Payment deferral on hybrid securities usually cannot trigger either a default on the hybrid itself or a cross-default on the issuer’s other obligations. In rating hybrid securities, Moody’s assumes hybrid investors expect to receive payments as scheduled.
An acceptable settlement mechanism is one that is viewed as effectively non-cumulative, according to Moody's hybrid basket methodology.
Moody’s Rating Methodology
3
The financial metrics used in setting meaningful mandatory deferral triggers usually vary from industry to industry. Furthermore, hybrid securities with mandatory deferral provisions may use a combination of more than one
financial ratio test for Moody's to consider the triggers meaningful. Some common financial ratio tests used in hybrids
with meaningful mandatory deferral triggers include:
• Negative GAAP income for four consecutive quarters combined with a decline in book capital and a cure
period which allows the capital base to be restored
• Gross cash flow less than X% of consolidated sales
• Interest coverage ratio less than or equal to X times
• Retained cash flow-to-debt ratio of less than X%
• Tangible equity below X% of assets under management (for an asset manager)
Global Application of Notching Guidelines
The guidance presented here is global and applies to all industries. It is expected that the vast majority of corporate
ratings will conform to these guidelines. Certain exceptions, however, will be made where Moody's believes the terms
of a security materially increase an investor's expected loss beyond established norms. Consequently, some securities
may be subject to an additional notch. In particular, examples will be found in the case of certain European non-financial corporate issuers, banks, and reinsurers in certain countries (e.g. Germany and Switzerland).
European Non-Financial Corporate Issuers
While many European countries allow the issuance of preferred stock, the practice is rare due to a lack of investor
appetite. In addition, some issuers either lack a board resolution authorizing issuance of preferred stock, or have covenanted not to do so. For such firms, hybrid securities can act as a substitute for preferred stock. Hybrids issued by
European firms are typically classified as "deeply subordinated" notes, senior only to common stock. Moody's considers the junior position of such European corporate hybrid obligations as increasing an investor's expected loss to levels
typically associated with preferred stock, and therefore ratings on such hybrid instruments typically follow guidance
given for preferred stock. For example, a deeply subordinated hybrid instrument issued by a European corporate with
a senior unsecured rating at Ba2 or above would be rated two notches below the issuer's senior rating.
Banks
Moody's notching guidance uses an issuer's senior unsecured rating as a benchmark, or reference point, for determining the ratings on subordinated obligations. The rating methodology for banks first determines deposit ratings, then
in most cases sets senior unsecured debt ratings equal to the deposit ratings. Moody's does not believe, however, that
bank deposit ratings are always an appropriate notching benchmark.
Notching between a bank's deposit rating and more junior bond ratings may be wide in cases where Moody's
expects the sovereign government to support the depositors and senior debt holders of a failing bank, but may not provide the same support to junior bond holders. That is, Moody's believes that certain governments will try to push
down the losses of a failing bank on junior debt holders, while protecting depositors and other senior debt holders. For
a bank in such jurisdictions, these relatively higher levels of investors' expected loss may lead to wider notching for
hybrid ratings than indicated by the above guidelines.
Reinsurers
For reinsurers in certain countries (e.g. Germany and Switzerland), unlike primary insurers, senior debt holders are not
subordinate to policyholders, reflecting the regulatory protection that exists for primary insurance policyholders, but not
for reinsurance policyholders. As a result, while senior debt ratings for primary insurance operating companies are
notched below the Insurance Financial Strength Rating (IFSR), a reinsurer's senior unsecured debt will typically be rated
at the same level as the IFSR. However, this preferential parity status does not extend to subordinated or more junior
obligations, and such instruments are expected to bear a substantially greater loss in default than senior creditors (policyholders and senior debt).
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Moody’s Rating Methodology
Hence, Moody's rates subordinated debt in such cases two notches below senior - in line with the IFSR/subordinated debt notching differential for primary insurers. Consequently, the existence of a meaningful mandatory trigger
for the subordinated debt of a reinsurer with a senior rating of Ba2 or above, under the revised guidelines, would be
rated one notch lower than other subordinated debt and at the relevant preferred security rating level (three notches
below senior).
This was the rationale underlying Moody's February 2007 rating action which placed the hybrid ratings of two
reinsurers - Allianz SE (the holding company and reinsurer for the Allianz Group) and Swiss Re - on review for possible downgrade.4
4.
Please see "Moody's Set to Issue Revised Guidelines for Hybrid Securities," February 2006, available on moodys.com.
Moody’s Rating Methodology
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Related Research
Special Comments
Notching for Differences in Priority of Claims and Integration of the Preferred Stock Rating Scale,
November 2000 (61680)
Summary Guidance for Notching Secured Bonds, Subordinated Bonds, and Preferred Stock of Corporate Issuers,
September 2001 (70456)
Rating Methodologies
Rating Preferred Stock and Hybrid Securities, November 2006 (100692)
Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate
Obligors in Europe, Middle East and Africa: Recommended Framework, November 2006 (100673)
Probability of Default Ratings and Loss Given Default Assessments for Non-Financial Speculative-Grade Corporate
Obligors in the United States and Canada, August 2006 (98771)
Refinements to Moody's Tool Kit: Evolutionary, not Revolutionary!, February 2005 (91696)
Moody's Tool Kit: A Framework for Assessing Hybrid Securities, December 1999 (49802)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report
and that more recent reports may be available. All research may not be available to all clients.
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Moody’s Rating Methodology
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Moody’s Rating Methodology