Why the Subsidiary Bond Is Rated Below the Parent

One Company, Several Ratings

A rating agency assigns a issuer credit rating which reflects the overall creditworthiness of a company. Individual debt instruments issued by that company or its subsidiaries then receive their own broadcast ratings which may differ from the issuer's rating and from each other

The adjustment that produces these differences is called make notches from rating scale levels. A senior secured bond could receive an issuer rating upgrade; a subordinated bond downgraded

The differences reflect two things: where the instrument is located in the order of priority and where it is located in the corporate structure

It is worth keeping these two firmly separated because only the first is written into the bond documents. The second is a consequence of which legal entity issued the document and may be the greater of the two effects while still being invisible to anyone reading the terms

Priority Notching

The first source is simple seniority. In the event of default secured loans are satisfied with their collateral senior unsecured loans with the remaining assets and subordinated loans with whatever remains

Because ratings incorporate both the probability of default and the expected recovery an instrument that is more likely to recover receives a higher rating even if the probability of default is identical across the capital structure. All of an issuer's instruments default at the same time; they do not recover the same amount

Structural Subordination

The second source is more subtle and surprises people

Consider a holding company that owns operating subsidiaries. The operating businesses hold the assets and generate the cash. The holding company owns shares of them

The creditors of an operating subsidiary have direct rights to its assets. The creditors of the holding company only have the right to claim against the holding company whose main asset is the share capital of the subsidiaries and the share capital is behind all subsidiary creditors

Therefore the debt of the holding company is structurally subordinate to subsidiary debt even when both are unsecured and neither is contractually subordinated to the other. Nothing in the documents creates subordination. The corporate structure does

The agencies reduce holding company debt to reflect this and the size of the adjustment depends on how much debt is held by subsidiaries and whether upstream guarantees are in place

The phrase worth holding on to is that the holding company does not own the assets. It owns shares. A share is a residual claim that is a claim to whatever remains after the money owed by that company has been paid. Lending to an entity whose only asset is a residual claim means supporting all the creditors of the company that actually owns the machinery

The Same Cash Flow, Two Positions

The mechanism is easier to see with numbers. None of the following is a real company and each figure is illustrative and round

Imagine a group with an operating company that owns all the plant and earns all the income and a holding company above that owns the shares of the operating company and nothing else. Both have issued senior unsecured bonds. On paper the two instruments look like brothers

Now it winds up the group. The assets of the operating company are sold and the proceeds are paid to the creditors of the operating company because those creditors have a direct claim against the entity that owns the assets. Only what is left after full payment belongs to the shareholder and the shareholder is the holding company

That residual is the complete set available to bondholders of the holding companies

Follow the consequences. If the operating company's assets comfortably exceed its debts a healthy residual flows and the holding company's bonds recover well. If the operating company's assets roughly match its debts the residual is almost zero and the holding company's bonds recover almost nothing. The two outcomes can be on either side of a fairly small change in the value of the assets

Look at what caused the damage. It's not a subordination clause because there isn't one. It's not a collateral because nothing was promised. The holding company's creditors were left behind simply because of the position of the entity they lent to on the organizational chart

This is also why the size of the notching depends on the amount of debt the subsidiaries have. A group that has almost no operating company debt has very little standing between its holding company's creditors and assets and the adjustment is small. If the operating companies are loaded with debt the same holding company bond becomes a much weaker claim without a single word being changed in its documentation

Double Leverage, or the Same Capital Counted Twice

The final view above is the clear way to look at structural subordination. There is a going concern version that works long before anyone liquidates anything

A holding company can take on debt and inject the profits into a subsidiary as equity. The subsidiary now shows more equity which supports its own borrowing and helps it meet the capital requirements that apply to it. The group as a whole simply borrowed money and relabeled it as equity one level lower

The measure of this is the ratio between what the holding company has invested in its subsidiaries and the holding company's own capital. When that ratio exceeds one a portion of the subsidiary's capital was financed with loans from the holding company which is what double leverage means

The consequence goes directly back to the issue. Interest on the holding company's debt must be paid in cash and the holding company does not carry out operations so cash can only come as dividends from the subsidiaries. Those dividends are paid with what is left after the subsidiaries have served their own creditors. Therefore the structural subordination that determines recovery in a liquidation also determines whether interest will be paid next quarter

This is where the insurance restriction becomes more serious than technical. A regulated insurance subsidiary needs permission to pay upward dividends and the regulator's job is to protect policyholders. Therefore the dividend will most likely be blocked exactly when the subsidiary is under pressure which is exactly when the holding company needs it most. The cash stops at the moment when the structure is least able to cope with the shutdown

Why Guarantees Change the Answer

The standard remedy is a upstream guarantee in which operating subsidiaries guarantee the debt of the holding company giving those creditors a direct right at the operational level and eliminating structural subordination

Therefore one of the most important pieces of information about a debt is whether there are guarantees from which entities and whether they cover all major subsidiaries. A bond that appears identical to another may be several levels weaker because one is guaranteed and the other is not

Guarantees themselves carry limitations. They can be limited to avoid the risk of fraudulent transfer can be released on defined events and in some structures disappear if the guarantor ceases to be a restricted subsidiary which connects directly to the deployable techniques used in liability management

What Can Quietly Undo a Guarantee

Those limitations are worth discussing because a warranty is often treated as a binary fact when it is closer to a conditional fact

The cap is first. A guarantee is often limited to the maximum amount that can be given without the guarantor becoming insolvent or breaching anti-transfer rules leaving a company unable to pay its own creditors. This is a sensible legal protection and means that the guarantee may cover less than the full bond bringing the shortfall back to structural subordination

Release provisions are second and most important. Guarantees commonly fall automatically upon defined events: the guarantor is sold the guarantor ceases to be a restricted subsidiary or the secured debt is refinanced. None of them require the consent of the bondholder and each can be triggered by ordinary corporate activity

The definition of a restricted subsidiary is one where this becomes a real rather than a theoretical risk. Bond agreements divide the group into restricted subsidiaries which are within the perimeter of the agreement and unrestricted subsidiaries which are outside it. When the documents allow assets to be designated in an unrestricted subsidiary a group can move valuable assets beyond the scope of the security structure leaving the original creditors with claims against entities that no longer own the good businesses

That family of maneuvers is what liability management exercises are based on. The relevant point here is more limited: the protection against structural subordination is only as durable as the definitions that control which entities remain within the perimeter and those definitions were negotiated when the bond was issued and not when the group was under pressure

Where It Matters Most

Bank holding companies are the clearest case. Regulation requires that debt absorb losses in the holding company specifically so that it can be written off in resolution while the operating bank continues. That debt is structurally subordinated by design and rated accordingly which is one of the few places where subordination is a policy objective rather than an artifact

Insurance groups They have an additional complication as regulated insurance subsidiaries face restrictions on paying dividends in the initial stages. A holding company that pays debt from subsidiary dividends is exposed to a regulator deciding that those dividends cannot be paid

Leveraged structures They are often issued at multiple levels and the notch between them can span several rating categories which materially changes prices

The Bank Case Is Deliberate, Not Accidental

It is worth separating the banking example because it reverses reading the rest of this article. Structural subordination everywhere is a danger that investors must detect. In bank holding companies it is the characteristic around which the entire agreement is built

The problem regulators were solving is that a failing bank can't just stop. Deposits payments and market-facing obligations have to keep going over the weekend and historically the only way to do that was with public money

The design that emerged puts loss-absorbing debt at the top of the pack. When the bank fails the authorities write down or convert the debt and equity of the holding company recapitalizing the group from its own liabilities. The operating bank keeps its counterparties its depositors and its licenses intact because nothing was touched at that level

Structural subordination is precisely what makes this possible. The creditors of the holding companies are already behind the creditors of the operating companies so imposing losses on them before depositors follows the priority that the structure had established from the beginning

That is why the notches on these instruments are not a warning. It is the rating agency that correctly describes an instrument that was designed to absorb losses first and investors are compensated for that position in the spread

What an Investor Should Take From It

The practical instruction is to identify the issuing entity rather than the group name. Two bonds from the same familiar corporate brand can occupy very different positions and the symbol and marketing material will not tell you which one

The questions that resolve it are which legal entity issued the bond whether operating subsidiaries guarantee it how much debt the preceding subsidiaries have and whether there are restrictions on moving cash up. The rating already reflects the answers and understanding why explains what would change

The Bottom Line

Notching converts a single view of a company's creditworthiness into ratings of specific instruments that reflect priority and structural position. The priority component is intuitive and the structural component is the surprising one since the holding company's debt can rank behind the debt of the subsidiaries without any document indicating it. The presence and extent of upstream guarantees usually decide the difference and it is the first thing worth checking when two bonds from the same group have different ratings. The next question is what could eliminate thoseguarantees because the answer is rarely never