In credit ratings, a notch is a small step up or down in rating. In Moody's parlance, going from A1 to A2 is one notch down. In S&P and Fitch terminology, it would be from A+ to just A.
The term "notching" refers to the ratings agency's habit of rating related debt by simply adjusting the rating up or down a certain number of notches. For example, Merrill Lynch is rated Aa3 by Moody's. Merrill's subordinated debt is rated A1, or one notch lower. Their preferred stock is rated A2, or two notches below their senior debt. This reflects the fact that in the event of bankruptcy the senior debt is in a superior position versus either the sub or preferred. The truth is that notching is really not a result of careful analysis in most cases. Sub debt is almost always one notch below senior debt, and preferred stock one notch lower still. Sometimes if there is no sub debt the preferred might get better treatment, and sometimes if there is extensive secured debt the sub debt might be more than one notch lower.
In reality, the rating is supposed to reflect the expected loss on the bond. But in the case of sub debt, your probability of default is exactly the same as the senior note. However the severity of loss is much greater. Whether that translates to exactly one notch or not depends on a myriad of factors.
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