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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

Rating agencies often distinguish between issuer ratings and issue ratings. A senior unsecured bond and a subordinated bond are issued by the same corporation, and the agency assigns the subordinated bond a lower rating than the senior bond. What best explains this difference?

The difference reflects notching for recovery. The issuer defaults once regardless of which bond is held, so default probability is the same, but subordinated debt ranks lower and is expected to recover less, which raises expected loss and justifies a lower issue rating.

  1. AThe issuer has a higher probability of default on the subordinated bond
  2. BNotching reflects the lower expected recovery on subordinated debt given defaultCorrect
  3. CThe subordinated bond has a shorter maturity, which increases its default probability
  4. DAgencies are required to assign a rating one notch lower to every subordinated instrument regardless of recovery

Explanation

Both bonds share the same issuer default probability because default is an issuer event. The agency notches the issue rating down for the subordinated bond because its claim ranks lower, implying lower recovery and higher expected loss. Option four invents a fixed rule; option one wrongly gives different default probabilities.

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