The table below shows the debt structures of three companies with identical corporate family ratings:
Company A | Company B | Company C | |
Senior secured | 40.00% | 60.00% | 40.00% |
Senior unsecured | 30.00% | 30.00% | 40.00% |
Senior subordinated | 15.00% | 5.00% | 10.00% |
Subordinated | 15.00% | 5.00% | 10.00% |
Which company will most likely exhibit the largest notching adjustment?
- Company A
- Company B
- Company C
is company C the answer?
is it A
B is correct. Generally, the lower the senior unsecured rating, the larger the notching adjustment. In this case, the three companies have identical corporate family ratings, so we would next analyze each company’s debt structure to determine which company’s issues would most likely exhibit the greatest loss severity given default. Company B has substantially more secured debt than either Company A or Company C in its debt structure, so Company B’s lower-ranked issues will likely exhibit lower recovery rates and require larger notching adjustments than either Company A or Company C.
A is incorrect. Notwithstanding the fact that Company A has the largest percentage of subordinated debt in its capital structure, Company A would most likely experience a smaller notching adjustment than Company B because there is a lower percentage of higher-priority claims (secured debt) in its capital structure, which should result in higher recovery rates for its lower-rated credits (subordinated bonds). Higher recovery rates for subordinate bonds translate into smaller notching adjustments
C is incorrect. Company C would most likely experience a smaller notching adjustment than Company B because there is a lower percentage of higher-priority claims (secured debt) in its capital structure, which should result in higher recovery rates for lower-rated credits (subordinated bonds). Higher recovery rates for subordinated bonds translate into smaller notching adjustments