a.  The capital structure of the bonds is usually seen through the seniority levels of different bonds in the capital market.

b.  The seniority is decided based on the priority of claims over the underlying assets. The assets can be classified as secured and unsecured on the basis of priority.

c.  The secured debt is the one that has the first lien on the specified assets. The senior secured debt is also considered secured debt.

d.  The unsecured debt includes all the other debt that fall below the secured debt, in the seniority level as per the waterfall structure. The unsecured debt mostly includes the senior unsecured debt, senior subordinated debt, subordinated debt and junior subordinated debt, and so on.

Most of the corporate bonds are in the nature of senior unsecured. For this class, all the creditors at a given level are treated as one class, and therefore, they rank equally.

e.  The recovery rate of the different class of debt may vary on the basis of the level of:

     i.  seniority,

    ii.  industry, and

   iii.  stage of the credit cycle (i.e. economic cycle).

f.  The seniority rankings, as assigned by the two of the major rating agencies are as follows:

g.  It is extremely important for a bond to get rated, as it becomes extremely difficult for a bond to sell without ratings.

h.  There are basically two types of ratings provided by the issuing agencies: corporate family ratings (CFR) and corporate credit ratings (CRR).

CFR is the rating provided to the issuer and CRR is the ratings assigned to the issue. The issuer rating is generally provided to senior unsecured debt.

The issue rating may or may not always be equal to the issuer’s ratings. Thus, the issue ratings may be notched one below or above the issuer ratings for the investment-grade securities. For the non-investment grade securities, however, the issue rating may be notched two ratings below the issuer’s ratings.

i.  The main goal of the credit analysis is to calculate the expected loss which is nothing but the probability of default times the chances of not recovering the same.

For the investment-grade bonds having ratings of AA and above, the primary focus is on finding the probability of default. Whereas, for the lower grade or the non-investment grade bonds the primary focus is on finding the chances of recovery.

j.  The ratings do not always stay static over time; there may be a downgrade or upgrade in the ratings.

The agencies can and have been wrong, and they can’t incorporate unpredictable events. The ratings also tend to lag the market pricing of the risk. This is the reason why sometimes two bonds with equal ratings may have differed prices.

1.1.         Notching

a.  A company’s credit rating is largely dependent on its senior unsecured obligations.

b.  A company’s secured debt may be notched up by the rating agency, relative to the company’s ratings. And likewise, the subordinated debt may be notched down.

c.  The notching policies of the credit rating agencies should be such, that it reflects appropriately the recoverability of a particular issue.

1.2.         Risk in Relying on Agency Ratings

a.  The creditworthiness of an issue is dynamic. It is largely dependent on the changes in the environment and other situations, which might not get reflected in the ratings instantly. Thus, the evolution of credit quality over the holding period of the debt might not be reflected in the ratings.

b.  As observed, the valuations generally change faster than the change in ratings. Thus, the process of notching may not adequately reflect the price decline of bond that is lower ranked in capital structure.

c.  Ratings usually reflect the possibility of default and not the severity of a loss. Thus, the bonds with similar ratings may have different expected losses.

d.  It is difficult to forecast certain credit negative outcomes such as adverse litigations, leveraging of corporate transactions, some low likelihood high severity events such as natural calamities. This does affect the reliability of the ratings.