Notching and Instrument-Level Ratings

A rating agency assigns an issuer a corporate family rating reflecting its overall probability of default — but that same company's senior secured bank loan, senior unsecured bonds, and subordinated notes will often carry three different ratings. That spread of ratings around the issuer's central rating is called notching: each instrument is nudged up or down a notch or more depending on how much it would actually recover if the company defaulted.

How the notches are set

Recovery in a bankruptcy follows the priority of claims: secured creditors get paid from specific pledged collateral first, senior unsecured creditors share what's left among general assets, and subordinated creditors are paid only after both. Rating agencies estimate, using the amount of debt ahead of and behind each instrument in the capital structure, roughly what recovery each tranche would see, and translate that into a notch adjustment — often one notch up for senior secured, flat for senior unsecured, and one or two notches down for subordinated debt, though the exact gap depends on how much cushion of junior debt sits below each instrument.

This matters in practice because comparing yields across two bonds from the same company only makes sense once you know they're being compared to their own instrument rating, not the issuer's headline rating — a subordinated bond yielding more than a senior bond from the same issuer isn't necessarily "cheap," it's compensating for genuinely worse expected recovery.